CHAPTER 5

INTEREST RATES AND BOND

VALUATION
Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.

Basic

1. The price of a pure discount (zero coupon) bond is the present value of the par. Remember, even
though there are no coupon payments, the periods are semiannual to stay consistent with coupon bond
payments. So, the price of the bond for each YTM is:

a. P = $1,000/(1 + .04/2)34 = $510.03

b. P = $1,000/(1 + .10/2)34 = $190.35

c. P = $1,000/(1 + .14/2)34 = $100.22

2. The price of any bond is the PV of the interest payments, plus the PV of the par value. Notice this
problem assumes a semiannual coupon. The price of the bond at each YTM will be:

a. P = $35({1 – [1/(1 + .035)]46 }/.035) + $1,000[1/(1 + .035)46]

P = $1,000.00
When the YTM and the coupon rate are equal, the bond will sell at par.

b. P = $35({1 – [1/(1 + .045)]46 }/.045) + $1,000[1/(1 + .045)46]

P = $807.12
When the YTM is greater than the coupon rate, the bond will sell at a discount.

c. P = $35({1 – [1/(1 + .025)]46 }/.025) + $1,000[1/(1 + .025)46]

P = $1,271.54
When the YTM is less than the coupon rate, the bond will sell at a premium.

We would like to introduce shorthand notation here. Rather than write (or type, as the case may be)
the entire equation for the PV of a lump sum, or the PVA equation, it is common to abbreviate the
equations as:

PVIFR,t = 1/(1 + R)t

which stands for Present Value Interest Factor, and

 PVIFAR,t = ({1 – [1/(1 + R)]t }/R )

which stands for Present Value Interest Factor of an Annuity

These abbreviations are short hand notation for the equations in which the interest rate and the number
of periods are substituted into the equation and solved. We will use this shorthand notation in the
remainder of the solutions key.

3. Here we are finding the YTM of a semiannual coupon bond. The bond price equation is:

P = $1,050 = $25.50(PVIFAR%,26) + $1,000(PVIFR%,26)

Since we cannot solve the equation directly for R, using a spreadsheet, a financial calculator, or trial
and error, we find:

R = 2.293%

Since the coupon payments are semiannual, this is the semiannual interest rate. The YTM is the APR
of the bond, so:

YTM = 2  2.293% = 4.59%

4. Here we need to find the coupon rate of the bond. We need to set up the bond pricing equation and
solve for the coupon payment as follows:

P = $1,040 = C(PVIFA3.2%,25) + $1,000(PVIF3.2%,25)

Solving for the coupon payment, we get:

C = $34.35

Since this is the semiannual payment, the annual coupon payment is:

2 × $34.35 = $68.70

And the coupon rate is the annual coupon payment divided by par value, so:

Coupon rate = $68.70/$1,000

Coupon rate = .0687, or 6.87%

5. The price of any bond is the PV of the interest payment, plus the PV of the par value. The fact that the
bond is denominated in euros is irrelevant. Notice this problem assumes an annual coupon. The price
of the bond will be:

P = €47(PVIFA3.4%,16) + €1,000(PVIF3.4%,16)
P = €1,158.41
6. Here we are finding the YTM of an annual coupon bond. The fact that the bond is denominated in yen
is irrelevant. The bond price equation is:

P = ¥103,250 = ¥4,900(PVIFAR%,18) + ¥100,000(PVIFR%,18)

Since we cannot solve the equation directly for R, using a spreadsheet, a financial calculator, or trial
and error, we find:

R = 4.63%

Since the coupon payments are annual, this is the yield to maturity.

7. The approximate relationship between nominal interest rates (R), real interest rates (r), and inflation
(h) is:

R=r+h

Approximate r = .048 – .027

Approximate r =.021, or 2.10%

The Fisher equation, which shows the exact relationship between nominal interest rates, real interest
rates, and inflation is:

(1 + R) = (1 + r)(1 + h)
(1 + .048) = (1 + r)(1 + .027)
Exact r = [(1 + .048)/(1 + .027)] – 1
Exact r = .0204, or 2.04%

8. The Fisher equation, which shows the exact relationship between nominal interest rates, real interest
rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)
R = (1 + .018)(1 + .034) – 1
R = .0526, or 5.26%

9. The Fisher equation, which shows the exact relationship between nominal interest rates, real interest
rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)
h = [(1 + .121)/(1 + .076)] – 1
h = .0418, or 4.18%
10. The Fisher equation, which shows the exact relationship between nominal interest rates, real interest
rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)
r = [(1 + .114)/(1 + .039)] – 1
r = .0722, or 7.22%

11. To find the price of a zero coupon bond, we need to find the value of the future cash flows.
With a zero coupon bond, the only cash flow is the par value at maturity. We find the present
value assuming semiannual compounding to keep the YTM of a zero coupon bond equivalent
to the YTM of a coupon bond, so:

P = $10,000(PVIF2.45%,34)
P = $4,391.30

12. To find the price of this bond, we need to find the present value of the bond’s cash flows. So,
the price of the bond is:

P = $49(PVIFA1.90%,26) + $2,000(PVIF1.90%,26)
P = $2,224.04

13. To find the price of this bond, we need to find the present value of the bond’s cash flows. So,
the price of the bond is:

P = $92.50(PVIFA1.95%,32) + $5,000(PVIF1.95%,32)
P = $4,881.80

14. The coupon rate, located in the second column of the quote, is 5.500%. The bid price is:

Bid price = (139.5156/100)  $1,000

Bid price = $1,395.156

The previous day’s ask price is found by:

Previous day’s asked price = Today’s asked price – Change

Previous day’s asked price = 139.5781 – .1406
Previous day’s asked price = 139.4375

The previous day’s price in dollars was:

Previous day’s dollar price = (139.4375/100)  $1,000

Previous day’s dollar price = $1,394.375

15. This is a premium bond because it sells for more than 100 percent of face value. The current yield is
based on the asked price, so the current yield is:

Current yield = Annual coupon payment/Price

Current yield = $45/$1,381.250
Current yield = .0326, or 3.26%
 The YTM is located under the “Asked Yield” column, so the YTM is 2.373%.

The bid-ask spread is the difference between the bid price and the ask price, so:

Bid-Ask spread = 138.125 – 138.0625

Bid-Ask spread = (.0625/100) × $1,000
Bid-Ask spread = $.625

Intermediate

16. Here we are finding the YTM of semiannual coupon bonds for various maturity lengths. The bond
price equation is:

P = C(PVIFAR%,t) + $1,000(PVIFR%,t)

Miller Corporation bond:

P0 = $41(PVIFA3.1%,26) + $1,000(PVIF3.1%,26) = $1,176.73
P1 = $41(PVIFA3.1%,24) + $1,000(PVIF3.1%,24) = $1,167.55
P3 = $41(PVIFA3.1%,20) + $1,000(PVIF3.1%,20) = $1,147.41
P8 = $41(PVIFA3.1%,10) + $1,000(PVIF3.1%,10) = $1,084.87
P12 = $41(PVIFA3.1%,2) + $1,000(PVIF3.1%,2) = $1,019.11
P13 = $1,000

Modigliani Company bond:

P0 = $31(PVIFA4.1%,26) + $1,000(PVIF4.1%,26) = $841.90
P1 = $31(PVIFA4.1%,24) + $1,000(PVIF4.1%,24) = $849.08
P3 = $31(PVIFA4.1%,20) + $1,000(PVIF4.1%,20) = $865.29
P8 = $31(PVIFA4.1%,10) + $1,000(PVIF4.1%,10) = $919.29
P12 = $31(PVIFA4.1%,2) + $1,000(PVIF4.1%,2) = $981.17
P13 = $1,000

All else held constant, the premium over par value for a premium bond declines as maturity
approaches, and the discount from par value for a discount bond declines as maturity approaches. This
is called “pull to par.” In both cases, the largest percentage price changes occur at the shortest maturity
lengths.

Also, notice that the price of each bond when no time is left to maturity is the par value, even though
the purchaser would receive the par value plus the coupon payment immediately. This is because we
calculate the clean price of the bond.
 Maturity and Bond Price
$1,300

$1,200

$1,100
Bond Price

$1,000
Miller Bond
Modigliani Bond

$900

$800

$700
13 12 11 10 9 8 7 6 5 4 3 2 1 0
Maturity (Years)

17. Any bond that sells at par has a YTM equal to the coupon rate. Both bonds sell at par, so the initial
YTM on both bonds is the coupon rate, 6.5 percent. If the YTM suddenly rises to 8.5 percent:

PLaurel = $32.50(PVIFA4.25%,8) + $1,000(PVIF4.25%,8) = $933.36

PHardy = $32.50(PVIFA4.25%,46) + $1,000(PVIF4.25%,46) = $799.39

The percentage change in price is calculated as:

Percentage change in price = (New price – Original price)/Original price

PLaurel% = ($933.36 – 1,000)/$1,000 = –.0666, or –6.66%

PHardy% = ($799.39 – 1,000)/$1,000 = –.2006, or –20.06%

 If the YTM suddenly falls to 4.5 percent:

PLaurel = $32.50(PVIFA2.25%,8) + $1,000(PVIF2.25%,8) = $1,072.47

PHardy = $32.50(PVIFA2.25%,46) + $1,000(PVIF2.25%,46) = $1,284.74

PLaurel% = ($1,072.47 – 1,000)/$1,000 = +.0725, or 7.25%

PHardy% = ($1,284.74 – 1,000)/$1,000 = +.2847, or 28.47%

All else the same, the longer the maturity of a bond, the greater is its price sensitivity to changes in
interest rates. Notice also that for the same interest rate change, the gain from a decline in interest rates
is larger than the loss from the same magnitude change. For a plain vanilla bond, this is always true.

YTM and Bond Price

$2,500

$2,300

$2,100

$1,900

$1,700
Bond Price

$1,500
Bond Laurel
$1,300 Bond Hardy

$1,100

$900

$700

$500
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Yield to Maturity

18. Initially, at a YTM of 9 percent, the prices of the two bonds are:

PFaulk = $28.50(PVIFA4.5%,28) + $1,000(PVIF4.5%,28) = $740.24

PGonas = $61.50(PVIFA4.5%,28) + $1,000(PVIF4.5%,28) = $1,259.76

 If the YTM rises from 9 percent to 11 percent:

PFaulk = $28.50(PVIFA5.5%,28) + $1,000(PVIF5.5%,28) = $625.78

PGonas = $61.50(PVIFA5.5%,28) + $1,000(PVIF5.5%,28) = $1,091.79

The percentage change in price is calculated as:

Percentage change in price = (New price – Original price)/Original price

PFaulk% = ($625.78 – 740.24)/$740.24 = –.1546, or –15.46%

PGonas% = ($1,091.79 – 1,259.76)/$1,259.76 = –.1333, or –13.33%

If the YTM declines from 9 percent to 7 percent:

PFaulk = $28.50(PVIFA3.5%,28) + $1,000(PVIF3.5%,28) = $885.16

PGonas = $61.50(PVIFA3.5%,28) + $1,000(PVIF3.5%,28) = $1,468.18

PFaulk% = ($885.16 – 740.24)/$740.24 = +.1958, or 19.58%

PGonas% = ($1,468.18 – 1,259.76)/$1,259.76 = +.1654, or 16.54%

All else the same, the lower the coupon rate on a bond, the greater is its price sensitivity to changes in
interest rates.

19. The current yield is:

Current yield = Annual coupon payment/Price

Current yield = $64/$1,080
Current yield = .0593, or 5.93%

The bond price equation for this bond is:

P0 = $1,080 = $32(PVIFAR%,22) + $1,000(PVIFR%,22)

Using a spreadsheet, financial calculator, or trial and error we find:

R = 2.712%

This is the semiannual interest rate, so the YTM is:

YTM = 2  2.712%
YTM = 5.42%

The effective annual yield is the same as the EAR, so using the EAR equation from the previous
chapter:

Effective annual yield = (1 + .02712)2 – 1

Effective annual yield = .0550, or 5.50%
20. The company should set the coupon rate on its new bonds equal to the required return. The required
return can be observed in the market by finding the YTM on outstanding bonds of the company. So,
the YTM on the bonds currently sold in the market is:

P = $1,121.80 = $32(PVIFAR%,40) + $1,000(PVIFR%,40)

Using a spreadsheet, financial calculator, or trial and error we find:

R = 2.698%

This is the semiannual interest rate, so the YTM is:

YTM = 2  2.698%
YTM = 5.40%

21. Accrued interest is the coupon payment for the period times the fraction of the period that has passed
since the last coupon payment. Since we have a semiannual coupon bond, the coupon payment per six
months is one-half of the annual coupon payment. There are two months until the next coupon
payment, so four months have passed since the last coupon payment. The accrued interest for the bond
is:

Accrued interest = $68/2 × 4/6

Accrued interest = $22.67

And we calculate the clean price as:

Clean price = Dirty price – Accrued interest

Clean price = $945 – 22.67
Clean price = $922.33

22. Accrued interest is the coupon payment for the period times the fraction of the period that has passed
since the last coupon payment. Since we have a semiannual coupon bond, the coupon payment per six
months is one-half of the annual coupon payment. There are four months until the next coupon
payment, so two months have passed since the last coupon payment. The accrued interest for the bond
is:

Accrued interest = $76/2 × 2/6

Accrued interest = $12.67

And we calculate the dirty price as:

Dirty price = Clean price + Accrued interest

Dirty price = $1,060 + 12.67
Dirty price = $1,072.67
23. To find the number of years to maturity for the bond, we need to find the price of the bond. Since we
already have the coupon rate, we can use the bond price equation, and solve for the number of years
to maturity. We are given the current yield of the bond, so we can calculate the price as:

Current yield = .0695 = $63/P0

P0 = $63/.0695
P0 = $906.47

Now that we have the price of the bond, the bond price equation is:

P = $906.47 = $63{[(1 – (1/1.0714)t ]/.0714} + $1,000/1.0714t

We can solve this equation for t as follows:

$906.47(1.0714)t = $882.35(1.0714)t – 882.35 + 1,000

117.65 = 24.12(1.0714)t
4.877 = 1.0714t
t = log 4.877/log 1.0714
t = 22.976  23 years

The bond has about 23 years to maturity.

24. The bond has 13 years to maturity, so the bond price equation is:

P = $1,043.55 = $27(PVIFAR%,26) + $1,000(PVIFR%,26)

Using a spreadsheet, financial calculator, or trial and error we find:

R = 2.471%

This is the semiannual interest rate, so the YTM is:

YTM = 2  2.471%
YTM = 4.94%

The current yield is the annual coupon payment divided by the bond price, so:

Current yield = $54/$1,043.55

Current yield = .0517, or 5.17%

25. We found the maturity of a bond in Problem 20. However, in this case, the maturity is indeterminate.
A bond selling at par can have any length of maturity. In other words, when we solve the bond pricing
equation as we did in Problem 20, the number of periods can be any positive number.