Question

You observe the following market interest rates, for both borrowing and lending:

One-year rate = 5%

Two-year rate = 6%

One-year rate one year from now = 7.25%

Suppose you borrow $100 for two years, lend the proceeds for one year, and then lend the total interest and principal received for 1 year at the start of year 2 for one year. What is your gain to the nearest cent?

Answer 1

Step : 1	Borrow $ 100 for 2 years
	Interest Rate = 6%
	Amount Payable after 2 years = $ 100 (1+0.06)^2
	Amount Payable after 2 years = $ 112.36
Step: 2	Lend $ 100 for 1 year
	Interest Rate = 5%
	Amount Received at the end of first year = $ 100 (1+0.05)^1
	Amount Received at the end of first year = $ 105
	Lend the Amount Received for 1 year at the start of year 2
	Amount Received at the end of Second year = $ 105 (1+0.0725)^1
	Amount Received at the end of Second year = $ 112.6125
Step: 3	Computation of Gain
	Gain = Amount Received after 2 Years - Amount Paid after 2 years
	Gain = Step 2 - Step 1
	Gain = $ 112.6125 - $ 112.36
	Gain = $ 0.2525 = $ 0.25(approx)