Chapter 06 - Measuring and Calculating Interest Rates and Financial Asset Prices

Chapter 6
Measuring and Calculating Interest Rates
and Financial Asset Prices

Learning Objectives
You will learn how money market interest rates are determined and how those
interest rates are used by dealers when trading money market assets.
You will explore the important relationships between the interest rates on
bonds and other financial instruments and their market value or price.
You will be introduced to the many different ways lending institutions may
calculate the interest rates they charge borrowers for loans.
You will be able to determine how interest rates or yields on deposits in banks,
credit unions, and other depository institutions are figured.

Key Topics Outline

Measures of Interest Rates on Wholesale Money Market Assets.
Measures of Interest Rates and Prices on Stocks and Bonds.
The Yield to Maturity and Holding-Period Yields.
The Relationship between Interest Rates and Asset Prices.
Interest Rates Quoted by Institutional Lenders: Simple Interest, Add-on Rate,
Discount Method, the APR.
Home Mortgage Loan Rates.
Compounding Interest.
The APY on Deposits.

Chapter Outline
6.1. Introduction to Interest Rates and Asset Prices
6.2. Units of Measurement for Interest Rates
6.2.1. Calculating and Quoting Interest Rates
6.2.2. Basis Points
6.3. Interest Rates in the Wholesale Money Markets
6.3.1. Computing Interest Rates on Money Market Assets that are Sold at a
Discount
6.3.2. Holding-Period Yield on Money Market Assets Sold at a Discount
6.3.3. Interest Rate Quotations on U.S. Treasury Bills
6.4. Interest Rates on Bonds and Other Long-Term Debt Securities
6.4.1. Yield to Maturity (YTM)
6.4.2. Holding-Period Yield on Bonds and Other Long-Term Debt Securities
6.4.3. Understanding the Concepts of Yield to Maturity and Holding-Period
Yield
6.4.4. Price Quotations on U.S. Treasury Notes and Bonds
6.4.5. Price Quotations on Corporate Bonds
6.5. Interest Rates and the Prices of Debt Securities

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Chapter 06 - Measuring and Calculating Interest Rates and Financial Asset Prices

6.6. Rates of Return on a Perpetual Financial Instrument

6.6.1. The Rate of Return on Fixed-Income Perpetuities
6.6.2. Interest Rates and Stock Prices
6.6.3. Calculating the Holding-Period Yield on Stock
6.6.4. Price Quotations in Corporate Stock
6.7. Interest Rates Charged by Institutional Lenders
6.7.1. The Simple Interest Method
6.7.2. Add-On Rate of Interest
6.7.3. Discount Loan Method
6.7.4. Home Mortgage Interest Rate
6.7.5. Annual Percentage Rate (APR)
6.7.6. Compound Interest
6.7.7. The Annual Percentage Yield (APY) on Deposits

Key Terms Appearing in This Chapter

interest rate, 148 bank discount rate (DR), 149
basis point, 149 simple interest method, 164
investment rate (IR), 149 add-on rate, 165
perpetuity rate, 160 discount loan method, 165
coupon rate, 152 home mortgage interest rate, 166
yield to maturity, 152 annual percentage rate (APR), 167
holding-period yield (HPY), 153 compound interest, 168
present value, 154 annual percentage yield (APY), 169

Questions to Help You Study

1. Interest rates are often called the most important "price" within the financial
system. Why do you think this is so?
Answer: The interest rate is the price charged a borrower for the loan of money. If
the price is high, corporations will have to pay more to obtain the needed capital and
will not aggressively increase the level of production and hence will not hire as many
workers, etc.

2. What is different about interest rates, or the price of credit, from other prices
in the economy?
Answer: This price of credit is unique because it is really a ratio of two quantities: the
total required fee a borrower must pay a lender to obtain the use of credit for a
stipulated time period divided by the total amount of credit made available to the
borrower.

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Chapter 06 - Measuring and Calculating Interest Rates and Financial Asset Prices

3. What exactly is a basis point? Why is it an important interest-rate measure?

Answer: A basis point is 1/100 of a percent and is used for reporting small changes in
interest rates.

4. What is meant by the par value of an asset, and what does it mean when an
asset is said to be sold at a discount to its par value?
Answer: The par value of an asset is the amount that the investor receives upon
maturity. When an asset is sold at a discount to its par value, it means the price the
investor pays for this asset will obviously be less than par value. The investors should
buy the asset at the price that less than par value; hence they have the incentives to
buy the asset.

5. What is the difference between an investment rate and a bank discount rate? As
an investor in money market asset, which one represents your actual rate of
return on your investment?
Answer: The investment rate (IR) is the actual rate of return that computes:
( ParValue Purchase Pr ice) 365
IR
Purchase Pr ice DaysToMaty rity
The bank discount rate (DR) is not the actual annualized rate of return on the
investment that is used only for trading purposes and is usually easier to compute than
the IR. The DR is less than the IR. The formula for the bank discount rate is:
( ParValue Purchase Pr ice) 360
DR
FaceValue DaysToMatu rity

6. What is the difference between the bid rate and the ask rate? Which one should
be higher? Why?
Answer: The bid rate is the discount rate that a dealer requires if he is to purchase the
T-bill and add it to his portfolio, and the ask rate is the discount rate an investor would
lock-in (assuming he held the T-bill to maturity) if he purchased the T-bill from a
dealer. The bid rate should be higher than ask rate, because the bid-ask spread (the
margin) enables a dealer to make a profit by creating this market.

7. How does the holding-period yield differ from the ask yield?
Answer: The holding-period yield is the annualized rate of return on an investment if
an investor chooses to sell the T-bill before it matures, but the ask yield is the actual
rate of return that the investor would receive if he bought the asset from the dealer and
held it until maturity.

8. Explain the meaning of the interest rate measure known as the yield to
maturity.
Answer: The yield to maturity represents the rate of return an investor would receive
if she bought the asset and chose to hold not sell the asset for its entire life. It
represents the rate of interest the market is prepared to pay for financial asset in order
to exchange present dollar for future dollars, which changes continuously with market
conditions.

9. What assumptions underline the calculation of the yield to maturity?

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Answer: It is assumed that the investor will hold the financial asset until it reaches
final maturity. It is also assumed that all cash flows to the investor can be reinvested at
the computed yield to maturity.

10. How does the holding-period yield on a debt security differ from the yield to
maturity?
Answer: The yield to maturity assumes that the investor will hold the financial asset
until its final maturity and that the cash flows to the investor can be reinvested at the
computed yield to maturity. The holding-period yield is the rate of return for an
investor who holds a bond or long-term debt security for a time and then sells it to
another investor in advance of the assets maturity. If the asset is held to maturity, its
holding-period yield equals its yield to maturity.

11. Carefully explain why bond yields and bond prices are inversely related?
What does this relationship tell you about the market value of a bond on a day
when interest rate rise? Would you want to be managing a portfolio of bonds on
that day? Why or why not?
Answer: The price of financial asset (especially for a bond or other debt security) and
its yield or rate of return are inversely related a rise in yield implies a decline in
price; conversely, a fall in yield is associated with a rise in the financial assets price.
Because investing in financial assets can be viewed from two different perspectives
the borrowing and lending of money or the buying and selling of financial assets.
When the demand of loanable funds is increasing, the equilibrium interest rate will
increase. This increases the supply of financial assets. Therefore the asset price will
decrease.
When the interest rate rises, the supply of financial assets will increase. Hence
the price of financial assets will fall. If you expect that in the future the interest rate
will decrease from an increase in the supply of loanable funds, then you should buy
more bonds at this price. The price of the bonds will increase, because the interest rate
will decrease.

12. When dealing in bonds, what are the differences between the bid price, the
ask price, the coupon rate, and the ask yield.
Answer: The bid price represents the price that dealers in T-notes and T-bonds
manage portfolios of those Treasury securities and stand ready to buy the T-notes or T-
bonds. The opposite if true of the ask price that represents the price at which dealers
are ready to sell.
The coupon rate is used to determine the amount of the annual interest income
received by the investor in the form of coupon payment (C) that is:
Coupon CouponRate ParValue
The ask yield is the yield to maturity an investor purchasing the Treasury from
the dealer would receive if he bought the security and held it to maturity.

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13. What is meant by the statement that a bond is selling above par? Below par?
Answer: The par value is the face value of the bond (often set to 100), and used to
compute the coupon payments. Note that if the dealer is willing to sell the T-note or T-
bond at less than par (below 100), then the yield to maturity is above the coupon rate.
For those T-notes and T-bonds selling above par (above 100), the yield to maturity is
below the coupon rate.

14. What is meant by a perpetual financial instrument? Give an example.

Answer: A perpetual financial instrument is the financial assets that never mature.
These assets may be either fixed-income securities, which promise to make periodic
payments of a known amount on pre-assigned dates, or variable-return assets, such as
corporate stock, where future payments, such as dividends, may change over time.

15. Why is it more difficult to determine the value of the payments received from
holding a stock (i.e., dividends) than the payments received from a perpetual
bond?
Answer: The payments received from a perpetual bond have a finite value, measured
by a financial assets current price (or present value). And there is an inverse (or
negative) relationship between the current price and the rate of return or yield on a
financial asset, especially for bonds and debt instruments.
The payment securities received from holding a stock have no guarantees both
expected dividends and the required risk-adjusted rate of return (r) may change at the
same time. The dividends paid by a corporation to its shareholders may vary in timing
and amount as the months and years go by.

16. Can you explain the logic behind the stock price formula (6.18)? Does it still
offer a way to assess the value of a share of stock for an investor, even if that
investor does not plan to hold the stock for more than a year?
Answer: The logic behind the stock price formula is the tracking changes in the
fundamental factors that appear to influence all stock prices the stream of
shareholder dividends a company is expected to pay in current and future time periods
and the minimum rate of return required by a companys shareholders. This minimum
required rate of return is used to discount the infinite stream of expected dividends to
determine their present values. In this formula, an investor can find the value of a
share of stock, even though he does not plan to hold the stock for more than a year.

17. Why is dividend yield not the full return that an investor in a stock would
expect to receive?
Answer: Because an investor in a stock would expect to receive a profit from a higher
share price of his stock. Both the share price and the dividend yield are the full return
to an investor.

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18. What is the PE ratio? What could it signal about the markets expectations of
future earnings for an individual firm?
Answer: The PE ratio is the firms price/earnings. This ratio is constructed by
dividing the Closing Price by the earnings reported by the firm for the prior four
quarters. An average PE ratio for the stock market as a whole is around 15. Firms
expected to experience rapid growth in earnings in the future will tend to have high
stock prices in relation to their prior years earnings, and hence a high PE.

19. Explain the meaning of the following terms and, where a formula is involved,
explain the components of each formula:
Answer:
a. Simple interest (I) - A method of determining the interest rate on a loan in
which interest is assessed only for the period of time the borrower actually has
use of loanable funds.
I Pr t
b. Add-on interest - Interest on a loan is calculated on the full principal amount
owed. The interest owed is then added to the principal and divided by the
number of payments to determine the size of each installment payment that
must be made.
c. Discount loan method - Borrower pays interest on a loan up front and
receives total loan amount less interest due.
d. APR - Actual rate on a loan, reflecting all credit costs and adjusted for the
declining amount owed on an installment loan, that must be quoted household
borrowers under federal law.
e. Compound interest - A lender or depositor of funds earns interest income on
both the principal amount of any funds owed and on accumulated interest as
well.
f. APY - Annual percentage yield on a deposit, which adjusts for the average
balance in the account and any fees charged the depositor and must be
reported to the depositor before opening a new account.
APY = 100[Annual interest earned / Daily average balance]

20. How is the monthly payment that a home mortgage borrower must meet
determined? Why is it that payments made early in the life of a typical home
mortgage go largely to pay interest rather than repay principal?
Answer: Home mortgage loans are amortized, which means that the principal is
repaid over the life of the mortgage. Home mortgage loan payments are calculated as
an annuity; that is equal monthly payments over the life of the loan. With an annuity,
interest is paid on the declining balance. Since most of the balance is still outstanding
in the early years of the life of the mortgage loan, most of the early payments are
interest payments rather than principal repayments.

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Problems and Issues

1. Suppose a 10-year bond is issued with an annual coupon rate of 8 percent
when the market rate of interest is also 8 percent. If the market rate rises to 9
percent, what happens to the price of this bond? What happens to the bonds
price if the market rate falls to 6 percent? Explain why?
ANSWER: Assume that the par value of the bond is $100. If the prevailing market
interest rate rises to 9 percent, the bonds price must decline until its annual yield
approached 9 percent -- a market value of about $93.50. If the market rate on
comparable securities falls to 6 percent, the bonds price will rise (to about $114.88)
so that its yield approximates the 6 percent yield available elsewhere in the market.

2. Preferred stock for XYZ Corporation is issued at par $50 per share. If
stockholders are promised an 8 percent annual dividend, what was the stocks
dividend yield at time of issue? If the stocks market price has risen to $60
per share, what is its dividend yield?
ANSWER: At par the current yield is 8 percent. In ratio terms this is $4/$50. If the
stocks market price climbs to $60, it still promises just $4 annually. Therefore, its
current yield will be 6.6% or $4/$60.

3. You plan to borrow $2,000 to take a vacation and want to repay the loan in a
year. The banker offers you a simple interest rate of 12 percent with
repayments in two equal installments, 6 months and 12 months from now.
What is your total interest bill? What is the APR? Would you prefer an add-
on interest rate with one payment at the end of the year? If the bank applied
the discount method to your loan, what are the net proceeds of the loan?
What is your effective rate of interest rate?
ANSWER:
The Simple Interest, the formula is:
I Pr t
I = $2,000 x 0.12 x 6/12 = $120 for the first six months interest.
I = $1,000 x 0.12 x 6/12 = $ 60 for the second six months interest.
The Total Interest Bill is $180.
APR:
APR = 2 x No. of payments x Annual interest cost
(Total no. of payments + 1) x Principal
= 2 x 2 x 180 = 12%
(2 + 1) x 2,000
No, I do not prefer one payment, because total repayment would be $2,240 instead of
$2,180 with simple interest method.
In the Discount method, the interest rate is $240 and the borrower will receive just
only $1,760 ($2,000 - $240). The effective interest rate is 13.6% (100 x $240/$1,760).

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4. An investor is interested in purchasing a new 20-year government bond

carrying a 10 percent annual coupon rate with interest paid twice a year. The
bonds current market price is $875 for a $1,000 par value instrument. If the
investor buys the bond at the going price and holds it to maturity, what will
be his or her yield to maturity? Suppose the investor sells the bond at the end
of 10 years for $950. What is the investors holding-period yield?
ANSWER: Using the equation (6.7); the number of period (n) = 40, the coupon
payment (C) = $50 (0.10 x $1,000 / 2), the market price of bond (P) = $875, and the
final price (M) = $1,000. After substitute, the yield to maturity is found to be y = 12%.
For the holding-period yield, we use the equation (6.11); the selling price after
10 years holding is $950. After substitute, the holding-period yield is h = 0.01192, or
11.92%.

5. Calculate the bank discount rate of return (DR) and the YTM-equivalent
return for the following money market instruments:
a. Purchase price, $96; par value, $100; maturity, 90 days.
b. Purchase price, $97.50; par value, $100; maturity, 270 days.
ANSWER: Using equation 6.3:
a. DR = [(100 96) / 100] x (360 / 90) = 0.16 or 16%
b. DR = [(100 97.50) / 100] x (360 / 270) = 0.033 or 3.3%
Using equation 6.2: Investment Rate
a. IR = [(100 96) / 96] x (365 / 90) = ((100-96)/96)*(365/90) = 0.168981 or
16.90%
b. IR = [(100 97.5) / 97.5] x (365 / 270) = ((100-97.5)/97.5)*(365/270) =
0.034663 or 3.47%

6. You have just placed $1,500 in a bank savings deposit and plan to hold that
deposit for eight years, earning 5-1/2 percent per annum. If the bank
compounds interest daily, what will be the total value of the deposit in eight
years? How does your answer change if the bank switches to monthly
compounding? Quarterly compounding?
ANSWER: Using equation (6.25):
FV P (1 r ) t
For daily compounding:
FV $1,500(1 0.055 / 365) 8*365 $1,500(1.5527) $2,328.95
For monthly compounding:
FV $1,500(1 0.055 / 12) 8*12 $1,500(1.5511) $2,326.72

For quarterly compounding:

FV $1,500(1 0.055 / 4) 8*4 $1,500(1.5481) $2,322.09

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7. You decide to take out a 30-year mortgage loan to buy the home of your
dreams. The homes purchase price is $120,000. You manage to scrape
together a $20,000 down payment and plan to borrow the balance of the
purchase price. Hardy Savings and Loan Association quotes you a fixed
annual loan rate of 12 percent. What will your monthly payment be? How
much total interest will you have paid at the end of 30 years?
ANSWER: The monthly payment is using equation (6.23):
3012
0.12 0.12
12 1 12 $35,949.64
$100,000
3012
$1,028.61
0.12 34.9496
1 12 1

The total interest paid is:

($1,028.91 12 30) $100,000 $270,407.60

8. A depositor places $5,000 in a credit union deposit account for a full year but
then withdraws $1000 after 270 days. At the end of the year, the credit union
pays her $300 in interest. What is this depositors daily average balance and
APY?
ANSWER: The depositors average balance for the year is:

Daily Average Balance = $5,000 x 270 days + $4,000 x 95 days = $4,739.73

365 days
Then:
APY = 100[$300/$4,739.73] = 6.33%

9. A commercial loan extended to CIBER-LAND Corporation for $2.5 million

assesses an interest charge of $350,000 up front. Using the discount method of
calculating loan rates, what is the effective interest rate on this loan? Suppose
that instead of deducting the interest owed up front, the companys lender
agrees to extend the full $2.5 million and add the amount of interest owed to
the face of CIBERs note. What, then is the loans effective interest rate?
ANSWER: Using the discount interest formula: $350,000/($2,500,000-$350,000) =
16.28%. For the second part, assuming the interest assessed on the loan remains
$350,000, then the effective interest rate is: $350,000/($250,000,000+$350,000) =
13.98%.

EXCEL 10. Bill Evans won a cash prize of $100,000 in a charity fund-raising
event. He decided to invest the money for the next 5 years to help pay for his
sons college education. His financial advisor gave him two options for investing.
Option A is invest all of money in stock mutual fund tied to the S&P 500. Option
B is to buy a speculative stock, Advent-2 that has paid no dividends with 50
percent of Bills winnings and a 10-year T-note--a zero-coupon security--with the
remainder. The advisor gave Bill three potential scenarios that could affect the
value of these two investment portfolios.

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Scenario 1: the S&P 500 will appreciate 10 percent in each of the first two
years, and then grow at a 3 percent rate in the last 3 years, during which
time the price of Avent-2 is expected to double in the first year and remain
flat in the last 4 years, while the yield on the T-note falls from its current 4
percent to 2 percent.

Scenario 2: the S&P 500 will appreciate 10 percent in each of the

upcoming 5 years, Advent-2 will increase by 20 percent each year, and the
yield on the T-note will remain unchanged at 4 percent.

Scenario 3: the S&P 500 will appreciate 3 percent in the first 2 years and
5 percent in subsequent 3 years, while the price of Advent-2 will fall by 10
percent in of each the first 2 years and then remain flat thereafter, as the
yield on the T-note rises from 4 to 7 percent.

Use a spreadsheet to compute the future value after five years of the $100,000
investment under Option A and Option B for each of the three scenarios. Can
you say whether Option A or Option B is better investment strategy?

ANSWER: Scenario 1
Option A Appreciate Rate on S&P 500 The Stock Price
Beginning $100,000
Year 1 10% $110,000
Year 2 10% $121,000
Year 3 3% $124,630
Year 4 3% $128,369
Year 5 3% $132,220
Total value of Investment $132,220

Option B Advent-2 The Stock Price T-Note T-Note Price

Beginning $50,000 $50,000
Year 1 100% $100,000 4% $52,000
Year 2 0% $100,000 2% $53,040
Year 3 0% $100,000 2% $54,101
Year 4 0% $100,000 2% $55,183
Year 5 0% $100,000 2% $56,286
Total value of Investment $156,286

Under Scenario 1, the future value of option B is higher than the future value of
option A.

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Scenario 2
Option A Appreciate Rate on S&P 500 The Stock Price
Beginning $100,000
Year 1 10% $110,000
Year 2 10% $121,000
Year 3 10% $133,100
Year 4 10% $146,410
Year 5 10% $161,051
Total value of Investment $161,051

Option B Advent-2 The Stock Price T-Note T-Note Price

Beginning $50,000 $50,000
Year 1 20% $60,000 4% $52,000
Year 2 20% $72,000 4% $54,080
Year 3 20% $86,400 4% $56,243
Year 4 20% $103,680 4% $58,493
Year 5 20% $124,416 4% $60,833
Total value of Investment $185,249

Under Scenario 2, the future value of option B is higher than the future value of
option A.
Scenario 3
Option A Appreciate Rate on S&P 500 The Stock Price
Beginning $100,000
Year 1 3% $103,000
Year 2 3% $106,090
Year 3 5% $111,395
Year 4 5% $116,964
Year 5 5% $122,812
Total value of Investment $122,812

Option B Advent-2 The Stock Price T-Note T-Note Price

Beginning $50,000 $50,000
Year 1 -10% $45,000 7% $53,500
Year 2 -10% $40,500 7% $57,245
Year 3 0% $40,500 7% $61,252
Year 4 0% $40,500 7% $65,540
Year 5 0% $40,500 7% $70,128
Total value of Investment $110,628

Under Scenario 3, the future value of option A is higher than the future value of option
B.
We cannot predict the future. If the future is as same as Scenario 1&2, the investor
should invest in option B. But if the future is Scenario 3, the investor should invest in
option A.

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Web-Based Problems
1. The expression for computing the per-share stock price for a firm that is
expected to have a constant dividend growth rate is given in Equation 6.19 in
the text. This equation can be useful in understanding how the financial
markets arrive at stock values for well-established firms operating in
different markets. For example, consider IBM and American Electric Power
(AEP)both leaders in their industries and expected to experience relatively
stable growth. We can use Equation 6.19 and data from the market to
compute the markets expectation of earnings growth, which will be reflected
in dividend growth, for these two companies
a. Assume the markets demand a 6 percent return for investing in either
IBM or AEP. Go the appropriate Web sites for these two companies, such
as www.yahoo.com, and find their current stock price and dividend. Use
Equation 6.19 to compute the markets expectation of dividend (earnings)
growth for these two firms. Which is larger? See if you can explain why
by discussing the nature of the businesses these two companies are
engaged in.
Answer: From equation 6.19:
SP D0 (1 r ) /(r g )
For IBM on July 12, 2007, the rate of return for investor (r) = 6%, Selling Price (SP)
= $109.12, the current dividend (D0) = 1.60, then find expected annual growth rate
(g):
$109.12 1.60 (1 0.06) /(0.06 g )
And the result g = 0.04446 or 4.446%.
For AEP on July 12, 2007, the rate of return for investor (r) = 6%, Selling Price (SP)
= $46.05, the current dividend (D0) = 1.56, then find expected annual growth rate
(g):
$46.05 1.56 (1 0.06) /(0.06 g )
And the result g = 0.02409 or 2.409%.
IBM gives the larger expected growth rate than AEP, because computer business has a
future in the growth of technology than saturated utility business.

b. Equation 6.19 is derived from the more general expression for stock
prices given by Equation 6.18 in the text. While Equation 6.19 can provide
a useful guideline for market pricing of equities issued by large, well
established firms like IBM and AEP, it often runs into trouble when used
to estimate stock values for new start-up firms or for established
companies changing their business plan. To see this, try to repeat the
process you followed in (a) for Amazon.com (AMZN) and eBay (EBAY).
What seems to be wrong? Can you explain why this equation fails to
provide a reasonable estimate of the expected growth for these firms?
Answer:

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For AMZN on July 12, 2007, the rate of return for investor (r) = 6%, Selling Price
(SP) = $72.79, the current dividend (D0) is N/A, and then we cannot find expected
annual growth rate (g).
For EBAY on July 12, 2007, the rate of return for investor (r) = 6%, Selling Price
(SP) = $34.23, the current dividend (D0) is N/A and then we cannot find expected
annual growth rate (g).
The assumption underlying the equation 6.19 is as follows: corporate dividends
(earnings) grow at a constant rate. For not-fully-established companies, the above
stability condition is difficult to be met and hence not applicable. Fast growing
companies often need more capital to grow and hence may plow any earnings back
into investment.

2. Go to the Treasurys Website and locate the results of its most recent auction
of 13-week (3-month) T-bill and of 10-yr T-notes. One route to locating this
information is:
http://www.treasurydirect.gov/RT/RTGateway?page=institHome
then click on the Auction Results for the 13-wk T-bill and the 10-yr T-
note.
a. For the 3-monthT-bill, obtain information on the Discount Rate. From
that information, along with the number of days to maturity, use formula
(6.3) to solve for the market price of the T-bill. (Compare this number
with what is reported.)
Answer: From equation 6.3:
( ParValue Purchase Pr ice) 360
DR
FaceValue DaysToMatu rity
For 13-wk on July 12, 2007, Par Value = $100, Discount Rate = 4.815%, Days to
Maturity = 91 days, then the market price is
(100 Purchase Pr ice) 360
0.04815
100 91
And the market price is $98.782875 that is the same as it is reported.
b. Using the market price for the T-bill that you obtained in part a., use
formula (6.2) to find the investment rate. (Compare this number with
what is reported.)

Answer: From equation 6.2:

( ParValue Purchase Pr ice) 365
IR
Purchase Pr ice DaysToMatu rity
For 13-wk on July 12, 2007, Par Value = $100, Market Price = $98.782875, Days to
Maturity = 91 days, then the investment rate is
(100 98.782875) 365
IR
98.782875 91
And the investment rate is 0.04942 or 4.942% that is close to the report is 4.956%.
c. From the information on the auction from the 10-yr T-note, did it sell
above, at, or below par?

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Chapter 06 - Measuring and Calculating Interest Rates and Financial Asset Prices

Answer: See the information below:

For 10-yr on July 12, 2007, Par Value = $100, Market Price = $94.399130, Days to
Maturity = 365days (9 years and 11 months), then the investment rate is
(100 94.399130) 365
IR
94.399130 365
And the investment rate is 0.01122 or 1.122% that is close to the report is 4.5%.
The auction from the 10-yr T-note shows that it sold below the par

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