Q1. David borrowed $900,000 to refurbish his holiday home. The loan requires monthly repayments over 15 years. When he borrowed the money, the interest rate was 12.6% per annum, but 18 months later the bank increased the rate to 14.1%, in line with market rates. The bank tells David he can increase his monthly repayment (so as to pay off the loan by the original agreed date) or he can extend the term of the loan (and keep making the same monthly repayment).

Required:

a) Calculate the new monthly repayment if David accepts the first option.

b) Calculate the extra period added to the loan term if David accepts the second option.

c) What is the total amount of interest paid by David under each option?

Q2. The current zero-coupon interest rates for terms 4 and 5 years are 7.4% and 7.5% per annum respectively. Meredith wishes to invest today and has an investment horizon of 4 years. Specifically, her target is to have $100,000 in 4 years' time. She is considering two investment strategies: (i) buying the 4 year bond and (ii) investing the amount calculated for the first strategy but instead buying the 5-year bond and selling the bond after 4 years have passed.

Required:

a) How much will Meredith need to invest today if she implements strategy (i)?

b) Suppose Meredith decides to implement strategy (ii). What 1-year interest rate in the fourth year, will see Meredith exceed her target?

c) How would the proponents of the expectations hypothesis interpret this result? How would proponents of the liquidity premium hypothesis interpret this result?