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Solutions - Lecture 3

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24 views12 pages

Solutions - Lecture 3

asd

Uploaded by

david.ellis1245
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© © All Rights Reserved
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Lecture 3

Problem 1:
Imagine that a bank pays a 10 percent interest rate compounded semiannually •
What does it mean? • What is your annual interest rate payment?
Solution:
When a bank pays a 10 percent interest rate compounded semiannually, it means
the following:
 Compounded Semiannually: The bank will calculate and add interest to
the principal twice a year, every six months. Instead of applying the
full 10% annual interest at the end of the year, the interest is applied
in two installments. Each installment is half of the annual rate.
 Interest Rate Per Period: Since the interest is compounded
semiannually, the interest rate for each six-month period is:

So, the bank will add 5% interest to your balance after the first six months and
another 5% after the second six months.
What is your annual interest rate payment?
The effective annual interest rate (also called the Effective Annual Rate or EAR) will
be higher than 10% due to the compounding effect. It can be calculated using the
formula

Thus, the effective annual interest rate is 10.25%, meaning you would
effectively earn 10.25% interest over the year due to semiannual compounding.
Problem 2:
What is Jane Christine’s end-of-year wealth if she receives a monthly interest
payment of 2% on a $5 initial investment?
• What is the EAR?
• If we invest $5, the end of year value of the investment is calculated as
Problem 3:
What is Jane Christine’s end-of-year wealth if she receives a monthly
interest payment of 2% on a $5 initial investment?
• What is the APR? • What is the EAR?
Problem 4:
Harry DeAngelo is investing $5,000 at an annual percentage rate (APR) of
12 percent per year, compounded quarterly, for one year – What is his
wealth at the end of the year ?
Harry’s Wealth at the End of the Year:
Harry DeAngelo’s wealth at the end of the year will be approximately $5,627.53

Problem 5:
Suppose that the EAR is 6.09% and the interest rate is paid every six months. What
is the APR?

Solution:

Final Answer:
The APR is approximately 5.98%.
Problem 6:
Suppose that the EAR is 10.38% and the interest rate is paid every quarter. What is
the APR?
Solution:

Final Answer:
The APR is approximately 9.96%.

Problem 7:
Suppose the stated annual interest rate (APR) is 10%. What is the EAR?
Solution:

 If compounded annually, the EAR is 10%.


 If compounded quarterly, the EAR is approximately 10.38%.
 If compounded monthly, the EAR is approximately 10.47%.
Problem 7:
Suppose the APR is 10%. What is the cumulative return if your holding period is 20
days (assuming 365 days a year)? What is the cumulative return over 27 months?
Nominal and Real Interest Rates – the case of Inflation

Problem 8:
A bank offers a one-year interest rate of 10 percent – A deposit of $1,000 will be
$1,100 at the end of the year • Suppose the annual inflation rate is 6 percent.
Solution:
 The nominal return from the bank is 10%, increasing your $1,000 to
$1,100.
 The real interest rate, accounting for 6% inflation, is approximately
3.77%.
 The purchasing power of your money at the end of the year, after
inflation, will be about $1,037.74.

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