FINA 4120 Spring 2020 Homework #1

Group Homework #1 – Review of Basic Concepts

FINA 4120

This group homework assignment reviews basic present value calculations and different yield conventions—
concepts and techniques extremely useful for this course. The assignment can be done in a group of no more
than THREE students. Write ALL the group members’ names on the cover sheet.

Please hand in along with your answers any supporting calculations and graphs (if necessary). Your work
should be neat and well organized so that I can easily find your solutions to each of the questions.

1. (2017 Midterm) A Wall Street Journal article from 05/03/1982 discusses how to compare car offers

from GM, Ford, and Chrysler. Let’s focus on comparing the financing arrangements offered by those three.

The article assumes that you buy a car with a $10,000 base sticker price that will be financed using a 48

month loan with a 20% down payment and fixed monthly payments. The market rate for car loans is 16.5%

A.P.R. compounded monthly. The article compares the following three schemes:

i) Chrysler offers no concessions (you would have to finance the car loan at the market rate).

ii) Ford offers a 6% rebate that reduces your down payment (again, you would have to finance the

car loan at the market rate).

iii) GM offers loans below market rate at 12.8% A.P.R. (compounded monthly).

The article compares the three offers in the following way:

Monthly payment Total payment

Chrysler $228.78 $12,981.44
Ford $228.78 $12,381.44
GM $213.84 $12,264.32
and concludes that GM offers the best deal because it has the lowest total payment.

a) How did the Wall Street Journal arrive at those numbers? Show the analysis that leads to both the

monthly and total payments for each of the three offers.

b) Why is the analysis in the Wall Street Journal incorrect?

c) What is an appropriate way of comparing those three offers? Perform the correct analysis. Which

company offers the best deal?

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2. You have managed to save $50,000 and are buying your first house for $250,000. You are planning

to borrow $200,000 today (t=0) by taking out a 15 year mortgage that requires monthly payments at an APR

of 9%.

a) What are your monthly payments on the mortgage?

After 5 years pass, you are considering refinancing your old mortgage with a new 10 year mortgage. The

annual percentage rate on the new mortgage is 8%. In order to refinance, you must close the old mortgage

by paying the outstanding principal.

b) After 5 years, what is the outstanding balance of the old mortgage?

If you choose to refinance, you have to pay refinancing fees of $1,500. Assume that you do not have the

$1,500 but that you can borrow the $1,500 as part of your new mortgage (so the starting balance of the new

mortgage is the sum of the outstanding balance of the old mortgage at t=5 and the refinancing fees of

$1,500).

c) What are your monthly payments on the new mortgage?

d) Is it advantageous to refinance under those conditions? If so, by how much are you better off by

refinancing? If not, by how much are you worse off by refinancing?

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3. Attached to this problem set is a page from Foresight from the Art Institute of Chicago. It describes

the details of a charitable annuity agreement. Let’s focus on the figures for a one-person annuitant. For

example, if a donor is 50 years old what the donation is made, the donor receives an annual annuity equal to

6.5% of the donation until the donor dies. If the donor is 60 years old when the donation is made, the

annuity percentage is 6.9%. In this example, a donation of $100,000 would provide income to the 50-year

old donor of $6,500 per year for life. The same donation would provide income to the 60-year old donor of

$6,900 per year for life. Ignore tax effects for now.

a. Assume that the donor is 50 years old. Also assume that the donor and the Art Institute both have a

cost of capital equal to 5%. At what life expectancy would the donation begin to be a gift from the

Art Institute to the “donor”?

b. Assume that the donor is 60 years old and has a life expectancy of 25 years. Also assume that the

donor and the Art Institute both have a cost of capital equal to 10%. If the donor gives $1,000,000 to

the Art Institute for a charitable gift annuity, what is the true value of the gift to the Art Institute?
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FINA 4120 Spring 2020 Homework #1

4. Which security has a higher effective annual interest rate?

a. A zero-coupon bond selling at $97,645 with par value $100,000 maturing in 3 months.

b. A coupon bond selling at par and paying a 10% coupon semiannually.

5. A WSJ article on 12/28/2015 urged millennials to ditch their parents’ homes and buy their own homes

now.1 It argues: “if, for instance, 30-year mortgage rates rise by one percentage point a year from now

and home prices rise by another 5%, a monthly mortgage payment could jump by around 18%.” Can you

verify this statement? Assume the house price is $500,000 and the 30-year mortgage rate is 4% (APR) at

the end of 2015. What’s the monthly mortgage payment? If you defer the purchase to the end of 2016,

what’s the new monthly mortgage payment (when the house price increases by 5% and the 30-year

mortgage rate becomes 5%)?

6. A large corporation issued both fixed and floating-rate notes 5 years ago, with terms given in the

following table:

9% Coupon Notes Floating-Rate Note

Issue size $250 million $280 million
Original Maturity 20 years 10 years
Current price (% of par) 93 98
Current Coupon 9% 8%
Coupon adjusts Fixed coupon Every year
Coupon reset rule − 1-year T-bill rate + 2%
Callable 10 years after issue 10 years after issue
Call price 106 102.50
Sinking fund None None
Yield to maturity 9.9% −
Price range since issued $85-$112 $97-$102

a) Why is the price range greater for the 9% coupon bond than the floating-rate note?

b) What factors could explain why the floating-rate note is not always sold at par value?

c) Why is the call price for the floating-rate note not of great importance to investors?

1
“Housing Rebound: Time for Millennials to Leave the Nest,” WSJ, 12/28/2015, by Steven Russolillo.
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d) Is the probability of call for the fixed-rate note high or low?

e) If the firm were to issue a fixed-rate note with a 15-year maturity, what coupon rate would it need

to offer to issue the bond at par value?

f) Why is an entry for yield to maturity for the floating-rate note not appropriate?

7. Masters Corp. issues two bonds with 20-year maturities. Both bonds are callable at $1,050. The first

bond is issued at a deep discount with a coupon rate of 4% and a price of $580 to yield 8.4%. The second

bond is issued at par value with a coupon rate of 8¾%. (Assume annual coupon payment)

a) What is yield to maturity of the par bond? Why is it higher than the yield of the discounted bond?

b) If you expect rates to fall substantially in the next 2 years, which bond would you prefer to hold?

c) In what sense does the discount bond offer “implicit call protection”?

8. The YTM on 1-year zero coupon bonds is 5% and the YTM on 2-year zero coupon bonds is 6%. The

YTM on 2-year maturity coupon bonds with coupon rates of 12% (paid annually) is 5.8%. What arbitrage

opportunity is available given these prices? Show the cash flows from the arbitrage.

9. You are working at the investment bank “Gold in Sacks”. The table below shows the current

STRIPS prices that appear on your computer screen. In the table, “Bond Price” is the price for a STRIP that

pays $100 on the Maturity Date.

Maturity (years) Bond Price (Bj)

1 $97.94
2 $94.31
3 $89.84
4 $85.19

An associate at another major investment bank has a number of default free 5% coupon bonds with annual

coupons and face value $1,000. These bonds mature in exactly four years from today (i.e. there are four

remaining coupon payments). She calls you and offers to sell 10,000 of these bonds. What is the fair price

for each of these bonds today?

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10. OFO Bike Evaluation (15 points) (2018 Midterm)

OFO bike is a leading bike-sharing company in China mainland. They are considering EQUITY IPO in
HK financial market. You are working in the ECM team in one investment bank and the key step is to
estimate the value of the company. OFO bike now has 100 million register users. Each user deposit 500
HKD to be qualified to rent bikes. Research shows that users will withdraw their deposit 5 years later
(and stop using the service). Each time when one user rents a bike, on average they pay 5 HKD per time
and the data shows that each user rents 100 times per year. OFO bike owns assets that auditing company
values at 8 billion HKD (bikes, operation systems, patents and so on). The annual operation cost is 40
billion HKD. Assume OFO business model is risk free. The market is now facing a 5% flat yield curve.

a) What is the value of the firm? (10 points)

b) Suppose OFO users withdraw deposit after 10 years, then what is the value of the firm? (5 points)
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11. Central Exchange and Over the Counter (OTC) Market (20 points) (This is a general question, it is
not necessarily related to Fixed-income securities.) (2018 Midterm, this is the “hard” question)

One important reason for the existence of financial market is to aggregate information. Trading in the
market at least partially reveal investors’ private information, and other people may learn from those
trading behaviors.

Now consider a zero coupon bond trading in the financial market. For simplicity, assume that the value
of one unit of zero coupon bond is either 0 or 1. Each individual has ONE private signal on the true
value of the bond (you can interpret it as the information on default risk). The signal is binary, that is, it
is either G (good) or B (bad). Potential buyers possess signal from different information sources and they
would like to learn from other people. To make your analysis easier, each investor’s evaluation on the
bond solely depends on the difference between the number of G signals and the number of B signals. For
example, investors observing 2 G signals and 1 B signal value the bond the same as investors observing
3 G signals and 2 B signals (because 2-1=3-2). Of course, the evaluation would be higher if you observe
more G signals.

There are five potential buyers (1, 2, 3, 4, 5) in the market. To make your life easy (or relatively not that
difficult), assume each buyers can either buy one unit or choose not to buy (so shorting is not allowed
here). The price of the bond is fixed such that any investor observes 1 more G signal would love to buy
(that is to say, if you observes 2 G signals and 1 B signal, then you should buy it, but if you observes
equally many G signals and B signals, then your evaluation is lower than the price).

a) If the bond is traded in the central exchange, then everyone will submit their order together. In that
sense, they do not observe other investors’ trading behaviors and will make buying decision solely based
on their own private signals. If those five buyers observe signals as {G, G, B, B, B} (so first two
investors observe G while the last three investors observe B), how many buyers will choose to buy the
bond? (5 points)
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b) In the real world, most bond trade in OTC markets. A typical feature for OTC market is that people
trade one by one. Buyer 1 is the first one to arrive, and then buyer 2, and so on. Upon arrival, each buyer
has to determine whether they want to buy or not. They are not able to come back later. Each buyer
observes his own private signal and preceding buyers’ decisions (whether buy or not, but not other
investors’ private signals). Consider the buyer 2. If he observes a B signal, and knows that buyer 1
chooses to buy, what is his investment decision? What is his investment decision if he observes a G
signal and knows that buyer 1 chooses to buy? (5 points)

c) Now consider the buyer 3. If he observes a B signal, and knows that both buyer 1 and 2 choose to
buy, what is his investment decision? What is his investment decision if he observes a G signal, and
knows that both buyer 1 and 2 choose to buy? (5 points)
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d) If those five buyers in the OTC observe signals as {G, G, B, B, B} (the same as in part a), how many
buyers will choose to buy the bond? (5 points)
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