Question

4)         Find IRR for following cash flows:

                     0_____1_____2_____3_____4

                     ($100)    $10       $10     $10     $110

             

              a) use spreadsheet, make sure that you know the procedure

                     Show spreadsheet printout

                        b) use intuition: if initial cashflow is changed to (90) the IRR will be Higher/lower because _________________________________

       Hint: Consider the impact of a higher discount rate on the PV of a given set of cash flows.

5)         The Stated rate i=10% per year compounded semi-annually. TheEffective annual rate is                         __________%

              a) use built-in calculator/Excel functions

              b) use formula

6)         Term structure:           

                                    Two year rate is i=5% per year

                     Three year rate is i=6% per year

              Find the implied forward rate for the third year.                                                   i=_____%

7)    Real rate, r = 5% inflation rate, P = 2%

                        a)         Find thenominal rate (i) using approximate method, i.e. i = r+P                  i =______%

                        b)         Find thenominal rate (i) using the exact method,

                     i.e. 1+ i = (1+r)*(1+P)        i =_____%

8)    Do problem 9 using r = 5% and P = 100%

              a)    i =_____% approximately

              b)    i =_____% using the exact method.

            Note: Compare ‘a’ and ‘b’ in problems 8 and 9. The approximation isreasonable only when the rates are small.

Answer 1

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Question-5

Question-5 part(b)

Effective annual interest rate = [1*(1+r)^n -1] * 100

r= rate per period = 10%/2 = 5%

n= number of compounding per period

=>Effective annual interest rate = [1*(1.05)^2-1]*100 = 10.25%

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Question-6

Let forward rate for 3rd year be r%

hence,

(1*(1.05)^2)*(1+r) = 1*(1.06)^3

=>1.1025(1+r) = 1.191016

=>r = 8.0287%

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Question-7

(a)

Under approximation method=

Nominal Interest rate(i) = Real interest rate(r)+Inflation(p)

=>Nominal interest rate(i)= 5%+2% = 7%

(b)

Under Exact method or Fishers Equation=

(1+i)= (1+r)(1+p)

=>(1+i) = (1+5%)*(1+2%)

=>(1+i) = 1.05*1.02

=>1+i=1.071

=>i = 0.071 or 7.1%

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