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Homework_2 - CHAPTER 4 measures are misleading guides to...

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CHAPTER 4 Understanding Interest Rates 83 measures are misleading guides to the size of the interest rate, a change in them always signals a change in the same direction for the yield to maturity. 3. The return on a security, which tells you how well you have done by holding this security over a stated period of time, can differ substantially from the interest rate as measured by the yield to maturity. Long-term bond prices have substantial fluctuations when interest rates change and thus bear interest-rate risk. The resulting capital gains and losses can be large, which is why long- term bonds are not considered to be safe assets with a sure return. 4. The real interest rate is defined as the nominal interest rate minus the expected rate of inflation. It is a better measure of the incentives to borrow and lend than the nominal interest rate, and it is a more accurate indicator of the tightness of credit market conditions than the nominal interest rate. Key Terms basis point, p. 74 consol or perpetuity, p. 67 coupon bond, p. 63 coupon rate, p. 64 current yield, p. 70 discount bond (zero-coupon bond), p. 64 face value (par value), p. 63 fixed-payment loan (fully amortized loan), p. 63 indexed bond, p. 82 interest-rate risk, p. 78 nominal interest rate, p. 79 present discounted value, p. 61 present value, p. 61 rate of capital gain, p. 76 real interest rate, p. 79 real terms, p. 80 return (rate of return), p. 75 simple loan, p. 62 yield on a discount basis (discount yield), p. 71 yield to maturity, p. 64 Questions and Problems Questions marked with an asterisk are answered at the end of the book in an appendix, Answers to Selected Questions and Problems. *1. Would a dollar tomorrow be worth more to you today when the interest rate is 20% or when it is 10%? 2. You have just won $20 million in the state lottery, which promises to pay you $1 million (tax free) every year for the next 20 years. Have you really won $20 million? *3. If the interest rate is 10%, what is the present value of a security that pays you $1,100 next year, $1,210 the year after, and $1,331 the year after that? 4. If the security in Problem 3 sold for $3,500, is the yield to maturity greater or less than 10%? Why? *5. Write down the formula that is used to calculate the yield to maturity on a 20-year 10% coupon bond with $1,000 face value that sells for $2,000. 6. What is the yield to maturity on a $1,000-face-value discount bond maturing in one year that sells for $800? *7. What is the yield to maturity on a simple loan for $1 million that requires a repayment of $2 million in five years time? 8. To pay for college, you have just taken out a $1,000 government loan that makes you pay $126 per year for 25 years. However, you don t have to start making these payments until you graduate from college two years from now. Why is the yield to maturity necessar- ily less than 12%, the yield to maturity on a normal $1,000 fixed-payment loan in which you pay $126
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Homework_2 - CHAPTER 4 measures are misleading guides to...

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