1. Trish Harris has deposited $2,500 today in an account paying 6 percent interest annually.
What would be the simple interest earned on this investment in five years? If the account
paid compound interest, what would be the interest-on-interest in five years?
- Is = P x n x i = 2500 x 5 x 6% = 750
- Ic = P x (1+i)n – P = 2500 x (1+6%)5 – 2500 = 845,56
Interest-on-interest = 845,56 – 750 = 95,56
2. Joachim Noah is investing $5,000 in an account paying 6.75 percent annually for three
years. What is the interest-on-interest if interest is compounded?
- Is = 5000 x 6.75% x 3 = 1012,5
- Ic = 5000 x (1+6.75%)3 -5000 = 1082,38
- Ii = 1082,38 – 1012,5 = 69,88
3. Chung Lee wants to invest $3,000 in an account paying 5.25 percent compounded
quarterly. What is the interest on interest after four years?
5.25 %
- Is = 3000 x x 16 = 630
4
5.25 % 16
- Ic = 3000 x (1+ ) - 3000 = 695,98
4
- Ii = 65,98
4. Dat Nguyen is depositing $17,500 in an account paying an annual interest rate of 8.25
percent compounded monthly. What is the interest-on-interest after six years?
8.25 %
- Is = 17500 x x 72 = 8662,5
12
8.25 % 72
- Ic = 17500 x (1+ ) - 17500 = 11160,13
12
- Ii = 2497,63
5. Richard Delgado invested $10,000 in a money market account that will pay 5.75 percent
compounded daily. How much will the interest-on-interest be after two years?
5.75 %
- Is = 10000 x x 730 = 1150
365
5.75 % 72
- Ic = 10000 x (1+ ) - 10000 = 1218,63
365
- Ii = 68,63
6. How does the after-tax yield on a $1,000,000 municipal bond with a coupon rate of 8%
paying interest annually compare with that of a $1,000,000 corporate bond with a coupon
rate of 10% paying interest annually? Assume that you are in the 25% tax bracket.
- Municipal bond:
+ Municipal bond interest is generally exempt from federal tax.
+ Interest received annually: 1 000 000 x 8% = 80 000
After-tax yield = 8%
- Corporate bond:
+ Interest received annually: 1 000 000 x 10% = 100 000
+ Interest after pay 25% tax: 100 000 x (100% - 25%) = 75 000
75 000
After-tax yield = = 7.5%
1000 000
The after-tax yield on municipal bond higher than the after-tax yield on corporate bond
7. Debt issued by Southwest Airways currently yields 24%. A municipal bond of equal risk
currently yields 16%. At what marginal tax rate would an investor be indifferent between these
two bonds?
8. Assuming that the expectations theory is the correct one of the term structure, calculate
the interest rates in the term structure for maturities one to six years:
a. 4%, 4%, 5%, 6%, 6%, 6%
1 year =4%
2 year = 4%
3 year = 4,33%
4 year = 4,75%
5 year = 5%
6 year = 5,16%
i 6 year (long-term) > i 2 year (short-term) : upward sloping
b. 5%, 5%, 4%, 4%, 4%, 4%
1 year =5%
2 year = 5%
3 year = 4.67%
4 year = 4.5%
5 year = 4.4%
6 year = 4.33%
i 6 year (long-term) < i 2 year (short-term) : downward sloping
c. Explain what is happening to yield curve.
9. Refer to the problem 8. Assume that instead of the expectations theory, the liquidity
premium theory takes place. What will be your answer to parts a and b of problem 8, if
the following liquidity premiums are expected? 0%; 0.25%, 0.5%, 0.75%, 1%, and 1.25%
respectively?
a. 4%, 4%, 5%, 6%, 6%, 6%
1 year =4% + 0%
2 year = 4% +0.25%
3 year = 4.33% + 0.5%
4 year = 4.75%+0.75%
5 year = 5%+1%
6 year = 5.16%+1.25%
b. 5%, 5%, 4%, 4%, 4%, 4%
1 year =5% + 0%
2 year = 5%+0.25%
3 year = 4.67%+ 0.5%
4 year = 4.5%+0.75%
5 year = 4.4%+1%
6 year = 4.33%+1.25%
10. The one-year interest rate over the next eight years will be 4%, 5.5%, 6%, 8.5%, 10%,
11.5%, 14%, and 15.5%. Using the expectations theory, what will be the interest rates on a
four-year bond, a six-year bond, and an eight-year bond?
4 year = 6%
6 year = 7.6%
8 year = 9.4%
11. Suppose that the expectations theory is true and that you can buy a three-year bond with
an interest rate of 6% or three consecutive one-year bonds with interest rates of 4%, 5%,
and 6%. Which option would you choose to undertake?
- I long-term of three consecutive one-year bonds = 5%
Choose three-year bond with an interest rate of 6%
12. One-year T-bill rates over the next five years are expected to be 4%, 5%, 6%, 6.5%, and 8%. If
five- year T-bonds are yielding 35.5%, what is the liquidity premium on this bond?
4 %+5 % +6 %+ 6.5 %+ 8 %
- Liquidity premium = 35.5% - = 29.6%
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