Chapter10TheBondMarket77
Quantitative Problems Chapter 10
1.
Abondpays$80peryearininterest(8%coupon).Thebondhas5yearsbeforeitmaturesatwhich
timeitwillpay$1,000.Assumingadiscountrateof10%,whatshouldbethepriceofthebond
(ReviewChapter3)?
2.
Azerocouponbondhasaparvalueof$1,000andmaturesin20years.Investorsrequirea10%
[Link]?(note,zerocouponbondsdonot
payanyinterest)(ReviewChapter3)?
3.
Considerthetwobondsdescribedbelow:
Maturity
CouponRate
(Paidsemiannually)
ParValue
BondA BondB
15yrs
20yrs
10%
6%
$1,000
$1,000
(a) Ifbothbondshadarequiredreturnof8%,whatwouldthebondspricesbe?
(b) Describewhatitmeansifabondsellsatadiscount,apremium,andatitsfaceamount(par
value).Arethesetwobondssellingatadiscount,premium,orpar?
(c) Iftherequiredreturnonthetwobondsroseto10%,whatwouldthebondspricesbe?
Problemsolutionforendofchapterandstudyguide
1. $924.18
2. $148.64
3. (a) BondA$1,172.92
BondB$802.07
(b) BondAissellingatapremium
BondBissellingatadiscount
(c) BondA$1,000
BondB$656.82
4.
A2year$1,000parzerocouponbondiscurrentlypricedat$819.00.A2year$1,000annuityis
currentlypricedat$1,[Link]$10,000inoneofthetwosecurities,whichisa
betterbuy?Youcanassume
(1) thepureexpectationstheoryofinterestratesholds,
(2) neitherbondhasanydefaultrisk,maturitypremium,orliquiditypremium,and
(3) youcanpurchasepartialbonds.
Solution: WithPV$819,FV$1,000,PMT0andN2,theyieldtomaturityonthetwoyear
zerocouponbondsis10.5%forthetwoyearannuities,PV$1,712.52,PMT0,FV
$2,000andN2givesayieldtomaturityof8.07%.Thezerocouponbondsarethebetter
buy.
Chapter10TheBondMarket78
5.
Considerthefollowingcashflows.Allmarketinterestratesare12%.
Year
CashFlow
1
160
2
170
3
180
4
230
(a) Whatpricewouldyoupayforthesecashflows?Whattotalwealthdoyouexpectafter2years
ifyouselltherightstotheremainingcashflows?Assumeinterestratesremainconstant.
(b) Whatisthedurationofthesecashflows?
(c) Immediatelyafterbuyingthesecashflows,allmarketinterestratesdropto11%.Whatisthe
impactonyourtotalwealthafter2years?
Solution: (a)
Price
160 170
180
230
552.67
2
3
1.12 1.12 1.12 1.12 4
ExpectedWealth 160 (1.12)1.5 170 (1.12)5
180
230
$733.69
5
1.12 1.121.5
(b)
160
170
180
230
(1)
(2)
(3)
2
3
1.12
1.12
1.124 2.50
Duration 1.12
552.67
(c)
ExpectedWealth 160 (1.11)1.5 170 (1.11).5
180
230
$733.74
.5
1.11 1.111.5
Sinceyouareholdingthecashflowsfortheirduration,youareessentiallyimmunized
frominterestratechanges(inthissimplisticexample).
6.
Theyieldonacorporatebondis10%anditiscurrentlysellingatpar.Themarginaltaxrateis20%.
Aparvaluemunicipalbondwithacouponrateof8.50%[Link]?
Solution: Theequivalenttaxfreeratetaxableinterestrate*(1marginaltaxrate).Inthiscase,
0.10(10.20)8%.Thecorporatebondoffersaloweraftertaxyieldgiventhe
marginaltaxrate,sothemunicipalbondisabetterbuy.
7.
Ifthemunicipalbondrateis4.25%andthecorporatebondrateis6.25%,whatisthemarginaltax
rateassuminginvestorsareindifferentbetweenthetwobonds?
Solution: Theequivalenttaxfreeratetaxableinterestrate*(1marginaltaxrate).Inthiscase,
0.04250.0625*(1X),orX32%.
8.
M&[Link].Thebondcanbeconvertedinto20sharesofcommon
equity(currentlytradingat$52/share).Thebondhas5yearsofremainingmaturity,a$1,000par
value,anda6%annualcoupon.M&Esstraightdebtiscurrentlytradingtoyield5%.Whatisthe
minimumpriceofthebond?
Solution: Thepricemustexceedthestraightbondvalueorthevalueofconversion(youwillsee
whyinthenextquestion).
Ifconverted,thedebtisworth$5220$1,040.
Assuminga5%YTMiscorrect,thepriceofstraightdebtiscomputedas:
PMT60;N5;FV1000;I5
ComputePV;PV1,043.29
Thebondmustbetradingforatleast1,043.29.
Chapter10TheBondMarket79
9.
Assumethedebtinthepreviousquestionistradingat1,[Link]
thissituation(arbitrage)?
Solution: (1) Short20sharesofM&Eat$52/share.
Cash
$1,0470 *
($1,0.35)
$5
(3) Convertthebondtoshares,andusetocloseshortposition.
Assumingthesetransactionsarecompletedsimultaneously,youmakearisklessprofitof$5.
*Typically,smallinvestorscannotshortstockandhaveuseoftheproceedsthebroker
[Link],[Link].
(2) Purchaseaconvertiblebond.
10. A10year,1,000parvaluebondwitha5%annualcouponistradingtoyield6%.Whatisthecurrent
yield?
Solution: Thecurrentpriceofthebondiscomputedasfollows:
PMT50;N10;FV1000;I6
ComputePV;PV926.40
Thecurrentyield50/926.405.4%
11. A$1,[Link]
6.713%anditsyieldtomaturityis10%.Whatisthepriceofthebond?
Solution: (1)
(2)
CY.06713Coupon/Price,orCoupon0.06713Price
Price(Coupon1000)/1.10.
Substitutingfrom(1),Price(0.06713Price1000)/1.10
SolveforPrice,Price$968.17
12. A1yeardiscountbondwithafacevalueof$1,000waspurchasedfor$[Link]
maturity?Whatistheyieldonadiscountbasis?
Solution: 9001000/(1YTM),orYTM11.11%
YDB(1000900)/1000*(360/365)9.86%
13. A7year,$1,000parbondhasan8%annualcouponandiscurrentlyyielding7.5%.Thebondcanbe
calledin2yearsatacallpriceof$1,[Link],assumingitwillbecalled
(knownastheyieldtocall)?
Solution: Thecurrentpriceofthebondiscomputedasfollows:
PMT80;N7;FV1000;I7.5
ComputePV;PV1,026.48
Usingthis,theyieldtocalliscalculatedasfollows:
PMT80;N2;FV1010;PV1,026.48
ComputeI;I7.018%
Chapter10TheBondMarket80
14. A20year$1,000parvaluebondhasa7%annualcoupon.Thebondiscallableafterthe10thyearfor
acallpremiumof$1,025.Ifthebondistradingwithayieldtocallof6.25%,thebondsyieldto
maturityiswhat?
Solution: Thecurrentpriceofthebondiscomputedusingtheyieldtocallasfollows:
PMT70;N10;FV1025;I6.25
ComputePV;PV1,068.19
Usingthis,theyieldtomaturityiscalculatedasfollows:
PMT70;N20;FV1000;PV1,068.19
ComputeI;I6.39%
15. A10year$1,000parvaluebondhasa9%semiannualcouponandanominalyieldtomaturityof
8.8%.Whatisthepriceofthebond?
Solution: Thepriceofthebondiscomputedasfollows:
PMT45;N20;FV1000;I8.8
ComputePV;PV1,013.12
16. Yourcompanyownsthefollowingbonds:
Bond
A
B
C
MarketValue
$13million
$18million
$20million
Duration
2
4
3
Ifgeneralinterestratesrisefrom8%to8.5%,whatistheapproximatechangeinthevalueofthe
portfolio?
Solution: Portfolioduration2(13/51)4(18/51)3(20/51)3.09
ValueDuration(i/(1i)OriginalValue
Value3.09(0.005/1.08)$51million$729,583
