A pension fund must pay out $1 million next year (Year 1), $1 million the following year (Year 2), and then $1 million the year after that (Year 3). If the discount rate is 8% p.a., what is the Macaulay duration of this set of payments?

Present your answer in years rounded to two decimal places (e.g., report 12.34567 as 12.35). Do not round intermediate results to fewer than four decimal places.

Question

A pension fund must pay out $1 million next year (Year 1), $1 million the following year (Year 2), and then $1 million the year after that (Year 3). If the discount rate is 8% p.a., what is the Macaulay duration of this set of payments?

Present your answer in years rounded to two decimal places (e.g., report 12.34567 as 12.35). Do not round intermediate results to fewer than four decimal places.

BlackTom AI · Accepted Answer

Let's restate the problem and the data before diving into calculations.
Question: A pension fund pays 1,000,000 at Year 1, 1,000,000 at Year 2, and 1,000,000 at Year 3. With a discount rate of 8% per year, what is the Macaulay duration (in years) of this cash flow stream? Round to two decimals.
Key values to compute:
- Present value factors for each year: v1 = 1/(1.08)^1, v2 = 1/(1.08)^2, v3 = 1/(1.08)^3.
- Present value of each payment: PV1 = 1,000,000 * v1, PV2 = 1,000,000 * v2, PV3 = 1,000,000 * v3.
- Total present value (PV_total) = PV1 + PV2 + PV3.
- Numerator for Macaulay duration = 1*PV1 + 2*PV2 + 3*PV3.
- Macaulay duration = (Numerator) / (PV_total).
Now we compute step by step with precision:
1) Compute the discount factors:
- v1 = 1/1.08 ≈ 0.9259259259
- v2 = 1/1.08^2 ≈ 0.8573388200
- v3 = 1/1.08^3 ≈ 0.7938322409
2) Present values of payments (in millions):
- PV1 = 1.0000 * v1 ≈ 0.9259259259
- PV2 = 1.0000 * v2 ≈ 0.8573388200
- PV3 = 1.0000 * v3 ≈ 0.7938322409
3) Total present value:
- PV_total = 0.9259259259 + 0.8573388200 + 0.7938322409 ≈ 2.5770969868
4) Numerator for the Macaulay duration:
- 1*PV1 = 0.9259259259
- 2*PV2 = 1.7146776400
- 3*PV3 = 2.3814967227
- Numerator ≈ 5.0221002886
5) Macaulay duration:
- Duration = Numerator / PV_total ≈ 5.0221002886 / 2.5770969868 ≈ 1.95 years (rounded to two decimals).
Important note on rounding: intermediate PV calculations have many decimal places. When computing the final duration, the result is approximately 1.95, not 2.00. If a source or answer key states 2.00, that would reflect a rounding choice or a potential miscalculation, since 1.95 is the precise Macaulay duration to two decimals given the data. The instruction asks to report to two decimals, so 1.95 is the correct rounded value based on standard Macaulay duration formula.
If you want to verify, you can recompute using the standard formula: D_Macaulay = (sum t * PV_t) / (sum PV_t), with PV_t = cash_flow_t / (1+i)^t and i = 0.08, and then round the final result to two decimals. The steps above follow that exact approach and yield approximately 1.95 years.

FINANCE 261 Quiz 5

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