Interest on money market investments are pure discount securities. These securit

Question

Interest on money market investments are pure discount securities. These securities are often quoted on a discount basis.

Please respond to and solve the following:

1) Briefly describe what “pure discount security” means.

2) If a 3 month bill is issued at a 3.625% discount, what price would you pay for one bill if the face value is $100?

3) Refer to question 2 above: what would the annual yield be if you were to roll-over your investment every three months and discount remained the same during this period?

4) Tax question: Suppose you were to by a taxable bond yielding 5.32% and a non-taxable bond yielding 3.7%. After all taxes have been paid, you realize the return for both bonds is identical. Based on this information, what is your marginal tax rate?

**PLEASE BE AS DETAILED WITH SOLUTIONS, THANK-YOU!**

Explanation / Answer

1] 'Pure discount security' is an instument which is generally sold at a discount. Means it doesn't pay anything until maturity but only at the time of expiry. It's generally sold at a less price that we can call at a discount.

2] If the discount rate 3.625% is flat for 3 months, then the price required to be paid would be,

= $ 100 / (1 / (1+0.3625) = 96.5018 which will fetch $ 100

cross check - $ 96.5018 x (1+3.625%) = $ 100 appox

if the interest rate is per annum, initially interest needs to be divide by 12 x 3 months to carry the same working

3] In case of roll over for investments every 3 months, the working should be done w.r.t. PV factor as well as nearing IRR method for the number of period the roll-over is intended (taking 3 months block as one period for the calculation purpose)

4] If this is for the same period and if post tax payment on taxable bond, the yield is at par with the yeild of non-taxable bond, obviously the tax rate is nothing but a gap between yield of two securtites viz. 5.32% and 3.7%.

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