Midterm Test

July 5, 2019

Prof. M. Pollanen
Solutions
There are 5 pages. Marks will only be given for the steps that lead to a
correct answer. Show your work and put final answers in boxes provided.

1. Rates (8 marks)

a) Suppose r = 12% is an annual nominal rate, compounded three times a

year. What is the equivalent annual nominal rate compounded quarterly?

1
057 1 4 Rate=
solvefor 11.944
re 4 it 0 314 0.1194 11
b) An amount is invested for one year at 6%, and the annual rate of inflation
is 2%. What is the return on the investment?

RI
Return=
0.91 1 0 0392
3.924
c) Spot rates of interest for zero-coupon government bonds are observed for
di↵erent terms to maturity as follows:

1-year spot interest rate 6.10

fix
2-year spot interest rate 6.30
3-year
4-year
spot
spot
interest
interest
rate
rate
6.50
6.75 44 y
The forward rate of interest from year 3 to 4 is? 7 toy
f3,4 =
7 507
d) Determine the internal rate of return for an investment costing $10,000
that is expected to produce net cash flows of $5,000 at the end of year 1,
$3,000 at the end of year 2, and $5,000 at the end of year 3. (You can use
trial and error to estimate the rate.)
IRR=
10000 500 t o
14417
349ft Ig
Let
cette
10000 t 500 o e t 3000c 5000C TO
trial and error c o 874
r 14.41T
 2. Loans (6 marks)

A loan of $10,000 at an annual nominal rate of 6.5% (compounded semi-

annually) is to be repaid over 10 years with semi-annual payments.

a) How much interest is paid in the 14th payment? 12 79

OP 687.7997 a 032 4245.04
45 3,1687
r OP 0.0325 4245.04 137.96 Answer:

137 96
b) How much principal is repaid as part of the 5th payment?

OPy 687.799,070.032 8476.56

principal repaid 687.79 ropy Answer:

412.36 412.36
c) What is the outstanding balance of the loan after 13 payments?

OP 687.79977 0.0325
4245.04
Answer:
4245.04
d) Immediately after the 13th payment, you decide to decrease the loan
length to 8 years. What is the amount of the new semi-annual payment?

Answer:

1507 97

y
2 8 13
 3. Investment Decision (4 Marks)

A farmer can purchase a steel barn with an estimated lifetime of 20 years. It

will cost $800,000 and will require $4,000 a year to maintain. Alternatively,
he can purchase a wooden barn with an estimated lifetime of 14 years. It will
cost $640,000 and require $8,000 a year to maintain. If the farmer requires
an e↵ective annual return of r = 10%, what should he do?
[Hint: Calculate NPVs using r.]

He should buy which barn?

Wood

NPV Steel barn gooooo EE 834054 25

Egg 20 year
cycle

NPV Wood barn 640000 698933.50

899g T
14 year
cycle
Direct comparison wood is better larger NPV

Tesmatchupatzoyears
could treat
this as a
cycle problem
STEEL BARN IS
Better
4. Duration and Immunization (6 Marks)

(a) If you are expected to receive $100 in 1 year, $200 in 2 years and $300
in 3 years, calculate the Macaulay duration of this cashflow stream if the
e↵ective annual yield is 10%.

Duration:

sina.is ii
2 27 years
 (b) An obligation of $1000 is due in 3 years and the current e↵ective annual
yield is 10% per yield. If only zero coupon bonds with face value of $100 and
maturity of 1 and 5 years are available, how many units of each bond should
you hold in a portfolio to immunize yourself against the risk of changes in
yield.

Units of 1-year bond: Units of 5-year bond:

4 13 6.05

Let x of unitsof I yea bonds

Let y of units of 5 year bonds

Price D xp type
100011.11 3 X 100 11 t y 100 1.155

Data
f D
E D D

iii
it s

Solve systemof equations 2 4.13

y 6.05