Student name:__________

TRUE/FALSE - Write 'T' if the statement is true and 'F'

if the statement is false.
1) If interest rates increase, the value of a fixed-income
contract decreases and vice versa.

⊚ true
⊚ false

2) At equilibrium, a security's required rate of return will

be less than its expected rate of return.

⊚ true
⊚ false

3) If a security's realized return is negative, it must have

been true that the expected return was greater than the
required return.

⊚ true
⊚ false

4) Suppose two bonds of equivalent risk and maturity expected return than the
have different prices such that one is a premium bond and one discount bond.
is a discount bond. The premium bond must have a greater

⊚ true
⊚ false

5) A bond with an 11 percent coupon and a 9 percent

required return will sell at a premium to par.

⊚ true
⊚ false

Version 1 1
6) A fairly-priced bond with a coupon less than the
expected return must sell at a discount from par.

⊚ true
⊚ false

7) All else equal, the holder of a fairly-priced premium

bond must expect a capital loss over the holding period.

⊚ true
⊚ false

8) The duration of a four-year maturity, 10 percent

coupon bond is less than four years.

⊚ true
⊚ false

9) All else held constant, the longer the time to maturity,

the lower the security's price sensitivity to an interest rate
change.

⊚ true
⊚ false

10) All else held constant, the greater a security's coupon,

the lower the security's price sensitivity to an interest rate
change.

⊚ true
⊚ false

11) For a given interest rate change, a 20-year bond's price

change will be twice that of a 10-year bond's price change.

Version 1 2
 ⊚ true ⊚ false

12) Any security that returns a greater percentage of the

price sooner is less price volatile.

⊚ true
⊚ false

13) A zero-coupon bond has a duration equal to its

maturity and a convexity equal to zero.

⊚ true
⊚ false

14) The lower the level of interest rates, the greater a

bond's price sensitivity to interest rate changes.

⊚ true
⊚ false

15) The higher a bond's coupon, the lower the bond's price
volatility.

⊚ true
⊚ false

16) All else held constant, higher interest rates lead to

lower bond convexity.

⊚ true
⊚ false

17) A 10-year maturity, zero-coupon bond will have lower

price volatility than a 10-year bond with a 10 percent coupon.

Version 1 3
 ⊚ true ⊚ false

18) Ignoring default risk, if a bond's expected return is

greater than its required return, then the bond's market price
must be greater than the present value of the bond's cash
flows.

⊚ true
⊚ false

19) The coupon rate represents the most accurate measure

of the bondholder’s required return.

⊚ true
⊚ false

20) All else held constant, the higher the interest rate is the
higher the duration.

⊚ true
⊚ false

MULTIPLE CHOICE - Choose the one alternative that 21) The required rate of
best completes the statement or answers the question. return on a bond is:

D) inversely
A) the interest rate that equates the current market related to a bond's risk and
price of the bond with the present value of all future cash coupon.
flows received. E) None of these
B) equivalent to the current yield for nonpar bonds. choices are correct.
C) less than the expected return for discount bonds
and greater than the expected return for premium bonds.

22) Duration is:

A) the elasticity of

Version 1 4
a security's value to small coupon changes. E) the second
B) the weighted average time to maturity of the derivative of the bond
bond's cash flows. price formula with respect
C) the time until the investor recovers the price of the to the yield to maturity.
bond in today's dollars.
D) greater than maturity for deep discount bonds and
less than maturity for premium bonds.

23) Which of the following bond terms are generally

positively related to bond price volatility? 1.I. Coupon rate
2.II. Maturity
3.III. YTM
4.IV. Payment frequency

D) II only
A) II and IV only E) II, III, and IV
B) I and III only only
C) II and III only

24) The interest rate used to find the present value of a

financial security is the:

D) realized yield
A) expected rate of return. to maturity.
B) required rate of return. E) current yield.
C) realized rate of return.

25) A security has an expected return less than its required

return. This security is:

E) a zero-coupon
A) selling at a premium to par. bond.
B) selling at a discount to par.
C) selling for more than its present value.
D) selling for less than its present value.

Version 1 5
26) A bond that you held to maturity had a realized return of 6 percent. If no default
of 8 percent, but when you bought it, it had an expected return occurred, which one of the
following must be true?

expected.
A) The bond was purchased at a premium to par. E) The bond must
B) The coupon rate was 8 percent. have been a zero-coupon
C) The required return was greater than 6 percent. bond.
D) The coupons were reinvested at a higher rate than

27) You would want to purchase a security if the price is ________ the required rate
________ the present value or if the expected return is of return.

D) less than or
A) greater than or equal to; less than or equal to equal to; less than or equal
B) greater than or equal to; greater than or equal to to
C) less than or equal to; greater than or equal to

28) A 10-year annual payment corporate bond has a underpriced, then list by
market price of $1,050. It pays annual interest of $100 and its how much.
required rate of return is 9 percent. Is the bond correctly
priced, overpriced, or underpriced? If it is overpriced or

E) Underpriced by
A) Correctly priced $9.32
B) Overpriced by $14.18
C) Underpriced by $14.18
D) Overpriced by $9.32

29) A 12-year annual payment corporate bond has a underpriced, then list by
market price of $925. It pays annual interest of $60 and its how much.
required rate of return is 7 percent. Is the bond correctly
priced, overpriced, or underpriced? If it is overpriced or

D) Overpriced by
A) Correctly priced
B) Overpriced by $7.29
C) Underpriced by $7.29

Version 1 6
$4.43
E) Underpriced by $4.43

Version 1 7
30) An eight-year corporate bond has a 7 percent coupon
rate. What should be the bond's price if the required return is
6 percent and the bond pays interest semiannually?

D) $1,052.99
A) $1,062.81 E) $1,049.49
B) $1,062.10
C) $1,053.45

31) A 15-year corporate bond pays $40 interest every six

months. What is the bond's price if the bond's promised YTM
is 5.5 percent?

D) $1,263.45
A) $1,261.32 E) $1,264.79
B) $1,253.12
C) $1,250.94

32) A corporate bond has a coupon rate of 10 percent and

a required return of 10 percent. This bond's price is:

E) not possible to
A) $924.18. determine from the
B) $1,000.00. information given.
C) $879.68.
D) $1,124.83.

33) A 10-year, annual payment corporate coupon bond has percent. The bond's market
an expected return of 11 percent and a required return of 10 price is:

D) less than its

A) greater than its present value. present value.
B) less than par. E) $1,000.00.
C) less than its expected rate or return.

34) An eight-year, annual payment, 7 percent coupon Treasury bond has a price

Version 1 8
of $1,075. The bond's annual expected rate of return must be:

D) 1.69 percent.
A) 13.49 percent. E) 4.25 percent.
B) 5.80 percent.
C) 7.00 percent.

35) A six-year, annual payment corporate bond has a

required return of 9.5 percent and an 8 percent coupon. Its
market value is $20 over its present value. What is the bond's
expected rate of return?

D) 9.03%
A) 8.00% E) 3.53%
B) 10.21%
C) 9.98%

36) Corporate Bond A returns 5 percent of its cost in PV

terms in each of the first five years and 75 percent of its value
in the sixth year. Corporate Bond B returns 8 percent of its
cost in PV terms in each of the first five years and 60 percent
of its cost in the sixth year. If A and B have the same required
return, which of the following is/are true? 1.I. Bond A has a
bigger coupon than Bond B.
2.II. Bond A has a longer duration than Bond B.
3.III. Bond A is less price-volatile than Bond B.
4.IV. Bond B has a higher PV than Bond A.

D) II and IV only
A) III only E) I, II, III, and IV
B) I, III, and IV only
C) I, II, and IV only

37) A corporate bond returns 12 percent of its cost (in

present value terms) in the first year, 11 percent in the second
year, 10 percent in the third year, and the remainder in the
fourth year. What is the bond's duration in years?

Version 1 9
 D) 3.75 years
A) 3.68 years E) 3.32 years
B) 2.50 years
C) 4.00 years

38) A semiannual payment bond with a $1,000 par has a 7

percent quoted coupon rate, a 7 percent promised yield to
maturity, and 10 years to maturity. What is the bond's
duration?

D) 5.20 years
A) 10.00 years E) 7.35 years
B) 8.39 years
C) 6.45 years

39) An annual payment bond with a $1,000 par has a 5

percent quoted coupon rate, a 6 percent promised yield to
maturity, and six years to maturity. What is the bond's
duration?

D) 4.16 years
A) 5.31 years E) 3.19 years
B) 5.25 years
C) 4.76 years

40) If an N-year security recovered the same percentage

of its cost in present value terms each year, the duration
would be:

D) N!/N2.
A) N. E) None of these
B) 0. choices are correct.
C) sum of the years/ N.

41) All is held constant, the ________ the coupon and the
________ the maturity; the ________ the duration of a bond.

Version 1 10
 E) None of these
A) larger; longer; longer choices are correct.
B) larger; longer; shorter
C) smaller; shorter; longer
D) smaller; shorter; shorter

42) A four-year maturity, zero-coupon corporate bond duration of ________

with a required rate of return of 12 percent has an annual years.

D) 3.71
A) 3.05 E) 4.00
B) 2.97
C) 3.22

43) A decrease in interest rates will:

E) not affect the

A) decrease the bond's present value. bond's duration.
B) increase the bond's duration.
C) lower the bond's coupon rate.
D) change the bond's payment frequency.

44) A 10-year maturity coupon bond has a six-year

duration. An equivalent 20-year bond with the same coupon
has a duration:

E) greater than 20
A) equal to 12 years. years.
B) less than six years.
C) less than 12 years.
D) equal to six years.

45) A six-year maturity bond has a five-year duration.

Over the next year, maturity will decline by one year and
duration will decline by:

A) less than one

Version 1 11
year. E) N/( N − 1)
B) more than one year. years.
C) one year.
D) N years.

46) An annual payment bond has a 9 percent required

return. Interest rates are projected to fall 25 basis points. The
bond's duration is 12 years. What is the predicted price
change?

D) −1.95%
A) −2.75% E) 2.75%
B) 33.33%
C) 1.95%

47) A bond that pays interest annually has a 6 percent interest rate change? (Do
promised yield and a price of $1,025. Annual interest rates are not round on intermediate
now projected to fall 50 basis points. The bond's duration is calculations.)
six years. What is the predicted new bond price after the

D) $987.44
A) $1,042.33 E) None of these
B) $995.99 choices are correct.
C) $1,054.01

48) A bond that pays interest semiannually has a 6 percent interest rate change? (Do
promised yield and a price of $1,045. Annual interest rates are not round intermediate
now projected to increase 50 basis points. The bond's duration calculations.)
is five years. What is the predicted new bond price after the

D) $1,019.64
A) $1,020.35 E) None of these
B) $1,069.65 choices are correct.
C) $1,070.36

49) Convexity arises

because:

Version 1 12
 rates.
A) bonds pay interest semiannually. E) duration
B) coupon changes are the opposite sign of interest increases at higher interest
rate changes. rates.
C) duration is an increasing function of maturity.
D) present values are a nonlinear function of interest

50) The duration of a 180-day T-Bill is (in years):

D) 0.
A) 0.493. E) indeterminate.
B) 0.246.
C) 1.

51) The duration of a 91-day T-Bill is (in years):

D) 0.
A) 0.325. E) Indeterminate.
B) 0.249.
C) 0.715.

52) For large interest rate increases, duration ________ duration ________ the rise
the fall in security prices, and for large interest rate decreases, in security prices.

E) None of these
A) overpredicts; overpredicts choices are correct.
B) overpredicts; underpredicts
C) underpredicts; overpredicts
D) underpredicts; underpredicts

53) Suppose you owned stock in a company for the last

three years. You originally bought the stock three years ago
for $30 and just sold it for $56. The stock paid an annual
dividend of $1.35 on the last day of each of the past three
years. What is your realized return on this investment?

Version 1 13
 D) 37.58%
A) 15.36% E) None of these
B) 36.14% choices are correct.
C) 26.85%

54) You are considering the purchase of a certain stock. end of Year 2, $1.45 at the
You expect to own the stock for the next four years. The end of Year 3, and $1.55 at
current market price of the stock is $24.50 and you expect to the end of Year 4. What is
sell it for $55 in four years. You also expect the stock to pay your expected return from
an annual dividend of $1.25 at the end of Year 1, $1.35 at the this investment?

D) 32.85%
A) 21.78% E) None of these
B) 18.36% choices are correct.
C) 26.68%

55) A preferred stock is expected to pay a constant percent. What is the fair
quarterly dividend of $1.25 per quarter into the future. The value (or price) of this
required rate of return, Rs, on the preferred stock is 13.5 stock?

D) $18.65
A) $37.04 E) None of these
B) $24.36 choices are correct.
C) $52.36

56) You are evaluating a company's stock. The stock just

paid a dividend of $1.75. Dividends are expected to grow at a
constant rate of 5 percent for a long time into the future. The
required rate of return (Rs) on the stock is 12 percent. What is
the fair present value?

D) $50.25
A) $26.25 E) None of these
B) $22.50 choices are correct.
C) $35.26

57) A common stock paid a dividend at the end of last year of $3.50. Dividends

Version 1 14
have grown at a constant rate of 6 percent per year over the price of $35 per share.
last 20 years, and this constant growth rate is expected to What is the expected rate
continue into the future. The stock is currently selling at a of return on this stock?

D) 8.4%
A) 18.7% E) None of these
B) 22.5% choices are correct.
C) 16.6%

58) A stock you are evaluating is expected to experience is 11 percent. Calculate the
supernormal growth in dividends of 12 percent over the next stock's fair present value.
three years. Following this period, dividends are expected to (Do not round intermediate
grow at a constant rate of 4 percent. The stock paid a dividend calculations.)
of $1.50 last year and the required rate of return on the stock

D) $27.48
A) $16.24 E) None of these
B) $21.56 choices are correct.
C) $24.25

59) The basic principle of valuation states that the value of

any asset is:

factor in valuation.
A) the present value of all future cash flows E) None of these
generated by the asset. choices are correct.
B) the sum of all future cash flows generated by the
asset.
C) the present value of next year’s cash flow only.
D) the degree of cash flow riskiness is not a relevant

60) You bought a stock three years ago and paid $45 per What was your annual
share. You collected a $2 dividend per share each year you compound rate of return?
held the stock and then you sold the stock for $47 per share.

C) 5.84%
A) 8.89%
B) 8.51%

Version 1 15
 D) 4.44%
E) 2.96%

Version 1 16
SHORT ANSWER. Write the word or phrase that best return? The required
completes each statement or answers the question. return? Explain.
61) Is the realized rate of return related to the expected

62) Conceptually, why does a bond's price fall when

required returns rise on an existing fixed income security?

63) A 15-year, 7 percent coupon annual payment your expected return

corporate bond has a present value of $1,055.62. However, different from your
you pay $1,024.32 for the bond. By how many basis points is required return?

64) What is convexity? How does convexity affect

duration-based predicted price changes for interest rates
changes?

65) An investor owned

a 9 percent annual payment
coupon bond for six years
that was originally
purchased at a 9 percent

Version 1 17
required return. She did not reinvest any coupons (she kept coupon? Why are your
the money under her mattress). She redeemed the bond at par. answers not equal to 9
What was her annual realized rate of return? What if she did percent?
reinvest the coupons but only earned 5 percent on each

66) Explain the effects of coupon and maturity on

volatility.

67) All else held constant, which would have a longer

duration: (a) a five-year fully amortized installment loan with
semiannual payments or (b) a five-year semiannual payment
bond? Why?

68) How does an increase in interest rates affect a

security's duration?

69) An investor is considering purchasing a Treasury bond immediately after the

with a 16-year maturity, a 6 percent coupon, and a 7 percent purchase, what is the
required rate of return. The bond pays interest semiannually. predicted price change in
a.What is the bond's modified duration? dollars based on the bond's
b.If annual promised yields decrease 30 basis points duration?

Version 1 18
70) You have five years until you need to take your money the coupons and earn 6
out of your investments to make a planned expenditure. Right percent. Will your realized
now, bonds are promising an 8 percent return. You buy a five- return be more or less than
year duration bond. After you buy the bond, interest rates fall the originally promised 8
to 6 percent and stay there for the full five years. You reinvest percent? Explain.

71) A nine-year maturity, AAA-rated corporate bond has a

6 percent coupon rate. The bond's promised yield is currently
5.75 percent and the bond sells for its fair present value. The
bond pays interest semiannually and has an annual duration of
7.1023 years.
a.What is the bond's convexity?
b.If promised yields decrease to 5.45 percent, what is the
bond's predicted new price, including convexity?
c.Based on your result in b, would you prefer to have a
bond with more or less convexity? Explain.

72) The preferred stock

of ACE pays a constant
$1.00 per share dividend.
The common stock of
ACME just paid a $1.00
dividend per share, but its
dividend is expected to

Version 1 19
grow at 4 percent per year forever. ABLE common stock also to pay for a share of each
just paid a dividend of $1.00 per share, but its dividend is stock? Which stock will
expected to grow at 10 percent per year for five years and give you the best return?
then grow at 4 percent per year forever. All three stocks have Explain.
a 12 percent required return. How much should you be willing

Version 1 20
Answer Key

Test name: Chapter 3

1) TRUE
2) FALSE
3) FALSE
4) FALSE
5) TRUE
6) TRUE
7) TRUE
8) TRUE
9) FALSE
10) TRUE
11) FALSE
12) TRUE
13) TRUE
14) TRUE
15) TRUE
16) TRUE
17) FALSE
18) FALSE
19) FALSE

Version 1 21
20) FALSE
21) E
22) B
23) D
24) B
25) C
26) D
27) C
28) C
Price = $100 × PVIFA [9%, 10 years] + I/Y = 9
$1,000 × PVIF (9%, 10 years) = $1,064.18; FV = −1,000
Solve for PV which
Market value is underpriced by $1,064.18 − is $1,064.18;
$1,050 = $14.18. Market value is
underpriced by
Calculator Method: $1,064.18 − $1,050
N = 10 = $14.18.
PMT = −100
29) D
Price = $60 × PVIFA [7%, 12 years] + $1,000 Calculator Method:
× PVIF (7%, 12 years) = $920.57;
N = 12
Market value is overpriced by $925 − PMT = −60
$920.57 = $4.43. I/Y = 7
FV = −1,000

Version 1 22
 Solve for PV which is $920.57; Market value
is overpriced by $925 − $920.57 = $4.43.
30) A
Price = $35.00 × PVIFA (6%/2, 8 years × 2) + PMT = −35
$1,000 × PVIF (6%/2, 8 years × 2) I/Y = 3
FV = −1,000
Calculator Method: Solve for PV which
N = 16 is $1,062.81.
31) B
Price = $40.00 × PVIFA (5.5%/2, 15 years × PMT = −40
2) + $1,000 × PVIF (5.5%/2, 15 years × 2) I/Y = 2.75
FV = −1,000
Calculator Method: Solve for PV which
N = 30 is $1,253.12.
32) B
When coupon rate = required return, price =
par.
33) D
34) B
$1,075 = $70 × PVIFA (E(r)%, 8 years) + PMT = 70
$1,000 × PVIF (E(r)%, 8 years); Solve using PV = −1,075
trial and error or a calculator. FV = 1,000
Solve for I/Y which
Calculator Method: is 5.80%.
N=8
35) D

Version 1 23
PV = $933.70 = $80 × PVIFA (9.5%, 6 years) The market value
+ $1,000 × PVIF (9.5%, 6 years); ($933.70 + is $933.70 + $20
$20) = $80 × PVIFA (E(r)%, 6 years) + =$953.70, using this
$1,000 × PVIF (E(r)%, 6 years); Solve using value solve for I/Y
trial and error or a calculator. to find E(r).
PV = −953.70
Calculator Method: PMT = 80
First find the Present Value of this bond. N=6
N=6 FV = 1,000
PMT = −80 Solve for I/Y to get
I/Y = 9.5 9.03%.
FV = −1,000
Solve for PV which is $933.70.
36) D
37) E
3.32 = (12% × 1) + (11% × 2) + (10% × 3) +
(67% × 4)
38) E
Σ[(t × CFt/(1.035)t)]/($1,000)
39) A
Σ[(t × CFt/(1.06)t)]/$950.83
40) C
41) E
42) E
Duration of zero-coupon bond definition.

Version 1 24
43) B
44) C
45) A
46) E
−12 × (−0.0025/1.09) = 0.0275, or 2.75%
47) C
$1,025 + [−6 × (−0.0050/1.06) × $1,025] =
$1,054.01
48) D
[(−5/1.03) × 0.0050 × $1,045] + $1,045 =
1,019.64
49) D
50) A
180/365 = 0.493
51) B
91/365 = 0.249
52) B
53) C
Use a financial calculator to solve for IRR as = $57.35
follows: Compute IRR =
CF0 = −$30, CF1 = $1.35, CF2 = $1.35, CF3 26.85%.
54) C

Version 1 25
Use a financial calculator to solve for IRR as Compute IRR =
follows: 26.68%.
CF0 = −$24.50, CF1 = $1.25, CF2 = $1.35,
CF3 = $1.45, CF4 = $56.55
55) A
Rs = (4 × $1.25) / 0.135 = $37.04
56) A
P0 = ($1.75 × 1.05)/(0.12 − 0.05) = $26.25
57) C
E( Rs) = ($3.50 × 1.06/$35) + 0.06 = 0.166,
or 16.6%
58) D
D1 = $1.50 × 1.12 = $1.68 Use the Calculator
D2 = $1.68 × 1.12 = $1.88 to solve for the
D3 = $1.88 × 1.12 = $2.11 NPV:
D4 = $2.11 × 1.04 = $2.19 CF0 = 0, CF1 =
$1.68, CF2 = $1.88,
P3 = $2.19/(0.11 − 0.04) = $31.31 CF3 = $33.42, I/Y =
11 to get NPV =
CF3 = $2.11 + $31.31 = $33.42. $27.48

59) A
60) C
Use a financial calculator to solve for IRR as CF0 = −$45, CF1 =
follows: $2, CF2 = $2, CF3 =

Version 1 26
$49,
Compute for IRR = 5.84%.
61) Yes and no. The required return the nature of risk. If
determines the initial size of the coupon and you repeat the same
the offer price and, as the r changes, it forces investment with the
the market price to change. As the buy and same terms over and
sell prices and reinvestment rates on coupons over, you should, on
change, the realized return will be affected. average, earn a
However, the required return is an ex-ante rate realized return equal
designed to compensate investors for risk. The to the required
realized return may be less than or more than return.
the expected or the required returns. That is
62) Since the cash flows are set by contract, higher-rate bonds,
the only way a new investor can expect to earn dropping the price
the new higher required return is to pay less and raising the
for the bond, so the price has to fall. Traders expected return.
sell the existing bond in favor of newer,
63) The difference between expected return $1,000 ×
and required return is 0.33%, or 33 basis [PVIFAE(r),15 years]
points, calculated as follows:
E( r) is 6.74% −
r = 6.41% 6.41% = 0.33%, or
33 basis points more
$ 1,055.62 = $ 70 × [PVIFAr,15 years] + than your r.
$1,000 × [PVIFAr,15 years]
Calculator
E( r) = 6.74% Solution:
First solve for the
$ 1,024.32 = $ 70 × [PVIFAE(r),15 years] + required return:

Version 1 27
PV = −1,055.62 PMT = 70
FV = 1,000 N = 15
PMT = 70 Solve for I/Y =
N = 15 6.74%.
Solve for I/Y = 6.41%. The difference
between expected
Now solve for the E( r): return and required
return is 6.74% −
PV = −1,024.32 6.41% = 0.33%, or
FV = 1,000 33 basis points.
64) Convexity is a measure of the nonlinearity price formula with
(curvature) of a change in a bond's price respect to a change
caused by a change in interest rates. The level in interest rates. As
of convexity increases for greater interest rate such, it is accurate
changes. Duration is a linear estimate of a only for extremely
bond's price change as the interest rate small changes in
changes from its current level. Due to interest rates.
convexity, the greater the interest rate change, Duration gives only
the greater the error in using duration to an approximation of
estimate the bond's price change. For a the actual value
multimillion-dollar bond portfolio, the dollar change for interest
errors can be quite significant. In abnormal rate movements that
markets, bond investors may face more or less are normally
risk than the bond's duration would imply. observed in the
market.
Using calculus, we can also answer as
follows:
Duration is the first derivative of the bond
65) You can't use the bond price formula in this case because of

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the lack of reinvestment. Finally, to solve for
r, using the financial
First alternative: Do not reinvest the coupons calculator, input FV
at all. = 1,612.17, PV =
PV = $1,000 purchase price (coupon = YTM −1,000, N = 6, PMT
when purchased) = 0, and solve for I
FV = $90 × 6 = $540 + $1,000 par = $1,540 to get 8.29%.
With a financial calculator, input: PV = The realized returns
−1,000, FV = 1,540, N = 6, PMT = 0 and are less than 9
solve for I to get 7.46%. percent because the
investor did not
Second alternative: Reinvest coupons at 5 reinvest the coupons
percent. at the required rate
PV = $1,000 purchase price (coupon = YTM of return. In order to
when purchased) earn a compound
The future value will be $1,000 plus the sum rate of return equal
of the future values of each of the $90 to the promised
reinvested at 5 percent. With a financial yield, an investor
calculator, first find the sum of the future must reinvest the
values of each of the $90. PMT = −90, I = 5, coupons and earn
N = 6, PV = 0, and solve for FV 1 to get the promised yield
$612.17 and then add $1,000 to this amount to for the remaining
get the FV = $612.17 + $1,000 = $1,612.17. time to maturity.
66) The longer the maturity, the greater the more quickly will
price sensitivity of an asset with respect to
interest rate changes. The larger the coupon
payments, or any interim cash flows, the lower
the price sensitivity of an asset with respect to
asset changes. In general, any security that
returns a greater proportion of an investment

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be less price volatile because this allows the
investor to respond to the interest rate change,
minimizing the opportunity cost.

Version 1 30
67) The bond will have a longer duration money back sooner.
because you receive interest payments only That makes the loan
until maturity, whereas the amortizing loan less volatile than the
pays principal and interest throughout the life bond.
of the loan. Hence, the loan pays more (%)
68) At higher interest rates, the present value which, in turn,
of more distant cash flows is reduced by a results in a shorter
greater amount than near-term cash flows due duration. The
to compounding. For example, the present converse is true for
value of the tenth cash flow falls more than falling interest rates.
the present value of the first cash flow if rates
rise. This shifts a greater portion of the present
value weights to the near-term cash flows,
69) a. The bond's price is $904.66 and the Predicted Δ Bond
bond's modified duration is found as follows: Price = −9.85 ×
−.0030 = .0295, or
Σ[(t × CFt/(1.035))t]/($904.66) = 10.19 years 2.95%; So, the $
is the duration; price change is
Modified duration = 10.19/1.035 = 9.85 years 0.0295 × $904.66 =
$26.72
b. With a decrease of 30 basis points in
annual promised yields:
70) You will earn the promised 8 percent will just be offset by
return. Because you chose a bond with a having a higher-
duration equal to the five-year time period, the than-expected sale
loss in reinvestment income from reinvesting price of the bond in
the coupons at 6 percent instead of 8 percent five years.
71) a. Bond's convexity:

Version 1 31
 rate 0.000
change 05
CX = 108 New r 2.8800% 2.8700%
×
[(ΔP−/P)
+
(ΔP+/P)]
P(Old) = $ P−
1,017.3
7
8
10 = 100,000 $
,000 1,016 1,018.
.67
ΔP−/P (0.0006 ΔP ($0.70
90093) 208) 0.7026

ΔP+/P 0.00069
0678
− +
[(ΔP /P) + (ΔP /P)] 5.84901
E−07
CX = 58.4900 =
6 Convexit
y

b. With a new promised YTM = 5.45 percent,

the YTM change is 30 basis points and the
bond's new predicted price is found as:
ΔP/P = -DurMod × ΔYTM + 1/2 × CX ×
ΔYTM2 = (−6.90385 × −0.0030) + (½ ×
58.49006 × 0.0032) = .0209748, or 2.09748%.

The bond's new price should be $1,017.37 +

(2.09748% × $1,017.37) = $1,038.714.
c. An investor would prefer more convexity,
with greater convexity or curvature; as yields
drop, the bond's price will increase more.

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72) ACE: P = 1/0.12 = $8.33 D5 × (1 + g2); P5 = D6/(r −
ACME: P = 1(1.04)/(0.12 − 0.04) = $13.00 g2); g2 = 4%
ABLE: D0 = $1; D1 through D5 grow at 10% per year, D6 =

g1 D1 D2 D3 D4 D5 D6 g2 r

ABL 10% 1.1 1.21 1.33 1.46 1.6 1.674 4.0 12% If the stocks are priced at
E 1 41 105 9304 0% their fair values as
1 calculated above, all three
D0 P5 = 20. will give the investor the
936 same pretax rate of return
63
of 12 percent. A good
1 1.1 1.21 1.33 1.46 22.
stock buy is one where the
1 41 547
14
price is less than the
P0 = $
present value of the
16.62 expected future cash flows,
regardless of the expected
growth rate in the cash
flows.

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