DEPARTMENT OF MATHEMATICS AND STATISTICS Theory of Interest 62-392 Test 2 SOLUTIONS M.

Hlynka Monday, March 31, 2008 Directions: You must show your work in ALL questions, including multiple choice. ! 1. (Jerry Veeh problem) A 15 year 1000 par bond has 7% semiannual coupons and is callable at par after 10 years. What is the price of the bond to yield 5% nominal semiannual. SOLUTION: Since yield is less than the coupon rate, the purchaser paid a premium for the bond. The issuer wants to end the coupon payments as soon as possible. so we assume the bond will be called after 10 years. Take a period to be 6 months. Thus P = Cv20 + F ra20| = 1000(1.02520) + 35a20|.025 = 1000(1.02520) + 35 1 1.02520 = 1155.892 .025

2. (old SOA problem) A 20-year loan of 20000 may be repaid under the following two methods: i) amortization method with equal annual payments at an annual eective rate of 6.5% ii) sinking fund method in which the lender receives an annual payment of 1600 and a lump sum of 20000 after 20 years accumulated through a sinking fund which earns an annual eective rate of j . Both methods require a payment of X to be made at the end of each year for 20 years. Set up an equation for j and check which of the following values of j is best. (A) .118 (B) .130 (C) .142 SOLUTION: 20000(.065) 20000 = Xa20|.065 so X = = 1815.13 1 1.06520 We also need 20000 = (1815.13 1600)s20|j or s20|j = 92.97 Check each of the three answers to get C is best. 3. An investor makes a payment of $200 immediately and a payment of $264 at the end of two years in exchange for a payment of $460 at the end of one year. (a) Find the equation of value for the interest rate i. (b) Find i. SOLUTION: The equation of value (at the end of year 2) is 200(1 + i)2 + 264 = 460(1 + i). This is a quadratic in i. 200 + 400i + 200i2 + 264 = 460 + 460i. so 4 60i + 200i2 = 0 so 1 15i + 50i2 = 0. We get i = .1 and i = .2. So the

interest rate is either 10% or 20%. We cannot eliminate either answer. They are both possible. 4. On January 1, 2005, an amount 100 was invested into a fund. X was deposited or withdrawn (you dont yet know which) on April 1, 2005. The balance in the fund on December 31, 2005 was 105. The dollar-weighted rate of return was 12%. Find X . (A) 6.43 (B) -6.43 (C) 5.91 (D) -5.91 (E) -5.00 SOLUTION: B (A + Ci ) 105 (100 + X ) = . A + Ci (1 ti ) 100 + X (3/4) 7 = 6.42. (The negative value indicates Thus 12 + X (.09) = 5 X so X = 1.09 a withdrawal.) .12 = 5. (old SOA Problem, simplied) Donald takes a loan to be paid with annual payments of 500 at the end of each year for 2n years. The annual eective interest rate is 4.94%. The sum of the interest paid in year 1 plus the interest paid in year n + 1 is equal to 720. Calculate the amount of interest paid in year 1. SOLUTION Both n and L (loan size) are unknown. 500(1 v2n ) + 500(1 vn ) = 720 (check formulas in the amortization table). So 500v2n 500vn + 280 = 0. This is a quadratic in vn so from the quadratic formula, vn = .4 (the other root is negative). We want the amount of interest paid in year 1, namely 500(1 v2n ) = 500(1 (.4)2 ) = 500(.84) = 420. 6. (Broverman exercise 4.1.2) A 6% bond maturing in 8 years with semiannual coupons to yield 5% convertible semiannually is to be replaced by a 5.5% bond yielding the same return. In how many years should the new bond mature? (Both bonds have the same price, yield rate and face amount. SOLUTION: Let P =price of bond 1 (= price of bond 2). 8 years means 16 periods. Bond 1 gives P = F v16 + F ra16| = F (1.025)16 + F (.03)a16|.025 . For bond 2, let n be the number of years. There are 2n periods. Bond 2 gives P = F (1.025)2n + F (.0275)a2n|.025 . Equating the two expressions and cancelling F gives 1.02516 + .03(1 1.02516)/.025 = 1.0252n + .0275(1 1.0252n)/.025. Thus 1.0252n/10 = 1.1 (1.02516 + .03(1 1.02516)/.025) = 0.03472499. Thus 2n(ln(1.025)) = ln(.3472499) so 2n = .5 ln(.3472499)/ln(1.025) and n = 21.41755 years. We round this to 21.5 years to get the nal coupon. 7. (Odufrey problem) The amount of principal repaid in the 3rd payment of a 5-year level payment loan at 9% is 300. What is the original loan value?

SOLUTION: Let L be loan amount and K be annual payment. Repayment amount in third year is 300 = Kv3 = K (1.09)3 . Thus K = 300(1.09)3 = 388.51. The loan amount is L = Ka5| = 1511.16. 8. (Ostaszewski problem) Chuck puts 100 into a fund on Jan. 1, 2007. On July 1, 2007, Chuck puts an additional amount X into the fund. On January 1, 2008, the fund balance is 200. The dollar-weighted return rate for 2007 is 4.4%, and the time-weighted return rate is 5%. Find the eective rate of return earned in the rst half of 2007. A. 3.39% B. 3.45% C. 3.81% D. 4.12% E. 4.76% SOLUTION: BAC 200 100 X .044 = = . A + C (.5) 100 + X (.5) Solve for X to get X = 95.6/1.022. Let i1 ,i2 be interest rates for the rst and second halves of the year. Then 1.05 = (1 + i1 )(1 + i2 ). (1)

Thus 200 = 100(1 + i1 )(1 + i2 ) + X (1 + i2 ) = 100(1.05) + X (1 + i2 ) = 105 + X (1 + i2 ). 95 So 1 + i2 = . Then from (1), X 1.05 1.05(X ) 1.05(95.6) = = = 1.03886. 1 + i1 = 1 + i2 95 95(1.022) Finally i1 = .033886. A 9. A loan of X has an eective annual rate 8%. It is to be repaid by the end of 10 years. If the loan is repaid with a single payment at time t = 10, the total interest paid is $468.05 more than if the loan were repaid by ten equal annual payments. Find the value of X . SOLUTION: TotalInterest1= X (1.08)10 X = X (1.0810 1) = 1.158925X X (10 a 10| ) = 0.4902949X TotalInterest2= a10| 468.05 = 1.158925X 0.4902949X = 0.6686301X so X = 700.01