Homework 01

SEEM 3590 Investment Science
Xuedong He, Fall 2016
Homework Set 1
(Due Sept. 21)
Reading
[L] Ch2: Section 15; Ch3: Section 18; Ch5: Sections 3, 4, 6.
([L] refers to Investment Science, 1st Edition by David Luenberger.)
Assignment
1. [L] Chapter 2: Exercise 6
(Sunk costs) A young couple has made a nonrefundable deposit of the first
months rent (equal to $1,000) on a 6-month apartment lease. The next day
they find a different apartment that they like just as well, but its monthly rent
is only $900. They plan to be in the apartment only 6 months. Should they
switch to the new apartment? What if they plan to stay 1 year? Assume an
interest rate of 12% and the rent is paid at the beginning of each month.
(Copy machines) Tow copy machines are available. Both have useful lives of 5
years. One machine can be either leased or purchased outright; the other must
be purchased. Hence there are a total of three options: A, B, and C. The details
are shown in Table 2.6. (The first years maintenance is included in the initial
cost. There are then four additional maintenance payments, occurring at the
beginning of each year, followed by revenues from resale.) The present values of
the expenses of these three options using a 10% interest rate are also indicated
in the table. According to a present value analysis, the machine of least cost,
as measured by the present value, should be selected; that is, option B.
Table 2.6
Copy Machine Options
Initial outlay
Yearly expense
Resale value
Present value (@10%)
A
6,000
8,000
0
31,359
Option
B
30,000
2,000
10,000
30,131
C
35,000
1,600
12,000
32,621
Option A is a lease; options B and C are purchases of two alternative

machines. All have 5-year lives.
It is not possible to compute the IRR for any of these alternatives, because all
cash flows are negative (except for the resale values). However, it is possible to
calculate the IRR on an incremental basis. Find the IRR corresponding to a
change from A to B. Is a change from A to B justified on the basis of IRR?
1

(An appraisal) You are considering the purchase of a nice home. It is in every
way perfect for you and in excellent condition, except for the roof. The roof
has only 5 years of life remaining. A new roof would last 20 years, but would
cost $20,000. The housing is expected to last forever. Assuming that costs will
remain constant and that the interest rate is 5%, what value would you assign
to the existing roof?
(APR) For the mortgage listed second in Table 3.1 (see [L] or lecture notes on
mortgage calculation), what are the expenses in additional to the points?
(Callable bond) The Z corporation issues a 10%, 20-year bond at a time when
yields are 10%. The bond has a call provision that allows the corporation to
force a bond holder to redeem his or her bond at face value plus 5%. After 5
years the corporation finds that exercise of this call provision is advantageous.
What can you deduce about the yield at that time? (Assume one coupon
payment per year.)
(The biweekly mortgage) Here is a proposal that has been advanced as a way for
homeowners to save thousands of dollars on mortgage payments: pay biweekly
instead of monthly. Specifically, if monthly payments are x, it is suggested that
one instead pay x/2 every two weeks (for a total of 26 payments per year). This
will pay down the mortgage faster, saving interest. The savings are surprisingly
dramatic for this seemingly minor modificationoften cutting the total interest
payment by over one-third. Assume a loan amount of $100,000 for 30 years at
10% interest, compounded monthly.
(a) Under a monthly payment program, what are the monthly payments and
the total interest paid over the course of the 30 years?
(b) Using the biweekly program, when will the loan be completely repaid, and
what are the savings in total interest paid over the monthly program? (You
may assume biweekly compounding for this part.)
(Duration) Find the price and duration of a 10-year, 8% bond that is trading
at a yield of 10%.
(Annuity duration) Find the duration D and the modified duration DM of a
perpetual annuity that pays an amount A at the beginning of each year, with
the first such payment being 1 year from now. Assume a constant interest rate
r compounded yearly.
(Bond selection) Consider the four bonds having annual payments as shown in
Table 3.9. They are traded to produce a 15% yield.
Table 3.9
End of year payments
Year 1
Year 2
Year 3
Bond A
100
100
100 + 1000
Bond B
50
50
50 + 1000
Bond C
0
0
0 + 1000
Bond D
0 + 1000
0
0
(a) Determined the price of each bond.

(b) Determined the duration of each bond (not the modified duration).
(c) Which bond is most sensitive to a change in yield?
(d) Suppose you owe $2,000 at the end of 2 years. Concern about interest
rate risk suggests that a portfolio consisting of the bonds and the obligation should be immunized. If VA , VB , VC , and VD are the total values
of bonds purchased of types A, B, C, and D, respectively, what are the
necessary constraints to implement the immunization? [Hint: There are
two equations. (Do not solve.)]
(e) In order to immunize the portfolio, you decide to use bond C and one other
bond. Which other bond should you choose? Find the amounts (in total
value) of each of these to purchase.
(f) You decided in (e) to use bond C in the immunization. Would other
choices, including perhaps a combination of bonds, lead to lower total
cost?
(The fishing problem) Find the solution to the fishing problem of Example 5.4
when the interest rate is 33%. Are the decisions different that when the interest
rate is 25%? At what critical value of the discount factor does the solution
change?

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What are the four options being considered for copying machines?

What value would you assign to an existing roof that has 5 years of life remaining on a home you are considering purchasing?

SEEM 3590 Investment Science

Xuedong He, Fall 2016

Option A is a lease; options B and C are purchases of two alternative

SEEM 3590 Investment Science

Xuedong He, Fall 2016

3. [L] Chapter 2: Exercise 9

SEEM 3590 Investment Science

Xuedong He, Fall 2016

(a) Determined the price of each bond.

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