Question

You can buy a $500 savings bond today for $250 and redeem the bond in 10 years for its full face value of $500. You could also invest in a money market account that pays 7% interest per year.

Which option is better, assuming they are of equal risk?

a The money market account is better because it pays more interest.

b The money market account is better because it requires a smaller investment.

c The savings bond is better because it earns a higher interest rate.

d The money market and savings bond both earn 7% interest, so they are equal in value. Cannot be determined.

Answer 1

Given

Purchase price of a Bond = $ 250

Redemption Value = $ 500

Time Period = 10 Years

We know that Future Value = Present Value ( 1+i)^n

Here I = Rate of interest

n = No.of Years

$ 500 = $ 250( 1+i)^10

$ 500/$ 250 = ( 1+i)^10

2 = ( 1+i)^10

( 2)^1/10 = 1+i

1.071773 = 1+i

1.071773= 1+i

1.071773-1= i

0.071773 = i

Rate of interest earned on saving bond is 7.1773%.

Rate of interest earned on saving bond is 7.1773% where as the rate of interest in Money Market account is 7%

Saving Bond is better because it earns higher rate of interest. So option c is Correct.