If the interest rate is 5%, what is the present value of a security that pays you $1, 050 next year and $1,102.50 two years from now? If this security sold for $2200, is the yield to maturity greater or less than 5%? Why?
Answer: PV = $1,050/(1. +.05) + $1,102.50/(1 + 0.5)2
PV = $2,000
If this security sold for $2200, the yield to maturity is less than 5%. The lower the interest rate the higher the present value.
Your favorite uncle advises you to purchase long-term bonds because their interest rate is 10%. Should you follow his advice?
Answer: It depends on where you think interest rates are headed in the future. If you think interest rates will be going up, you should not follow your uncle's advice because you would then have to discount your bond if you needed to sell it before the maturity date. Long-term bonds have a greater interest-rate risk.
Would it make sense to buy a house when mortgage rates are 14% and expected inflation is 15%? Explain your answer.
Answer: Even though the nominal rate for the mortgage appears high, the real cost of borrowing the funds is -1%. Yes, under this circumstance it would be reasonable to make this purchase.