Chapter6

Basicquestions(116)

1. The yield to maturity (YTM) is the required rate of return on a bond expressed as a nominal
annualinterestrate.Fornoncallablebonds,theyieldtomaturityandrequiredrateofreturn
are interchangeable terms. Unlike YTM and required return, the coupon rate is not a return
usedastheinterestrateinbondcashflowvaluation,butitisafixedpercentageoffacevalue
overthelifeofthebondusedtosetthecouponpaymentamount.Fortheexamplegiven,the
couponrateonthebondisstill10%,andtheYTMis8%.

2. Priceandyieldmoveinoppositedirections;ifinterestratesrise,thepriceofthebondwillfall.
This is because the fixed coupon payments determined by the fixed coupon rate are not as
valuablewheninterestratesrise.Hence,thepriceofthebonddecreases.

NOTE:Mostproblemsdonotexplicitlylistaparvalueforbonds.Eventhoughabondcanhave
anyparvalue,ingeneral,wehaveadoptedaparvalueof$1000.Wewillusethisparvalueinall
problemsunlessadifferentparvalueisexplicitlystated.

3. ThepriceofanybondisthePVoftheinterestpayment,plusthePVoftheparvalue.Noticethis
problemassumesanannualcoupon.Thepriceofthebondwillbe:

P=$60({1[1/(1+0.08)]9}/0.08)+$1000[1/(1+0.08)9]

P=$875.06

We would like to introduce shorthand notation here. Rather than write (or type, as the case
maybe) the entireequationforthePVofalump sum,orthe PVAequation,itiscommonto
abbreviatetheequationsas:

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

whichstandsforPresentValueInterestFactor

 PVIFAR,t=({1[1/(1+R)]t}/R)

whichstandsforPresentValueInterestFactorofanAnnuity

Theseabbreviationsareshorthandnotationfortheequationsinwhichtheinterestrateandthe
number of periods are substituted into the equation and solved. We will use this shorthand
notationintheremainderofthesolutionskey.Thebondpriceequationforthisproblemwould
be:

P=$60(PVIFA8%,9)+$1000(PVIF8%,9)

P=$875.06

4. Here,weneedtofindtheYTMofabond.Theequationforthebondpriceis:

P=$1038.50=$70(PVIFAR%,9)+$1000(PVIFR%,9)

NoticetheequationcannotbesolveddirectlyforR.Usingaspreadsheet,afinancialcalculator,
ortrialanderror,wefind:

R=YTM=6.42%

IfyouareusingtrialanderrortofindtheYTMofthebond,youmightbewonderinghowtopick
aninterestratetostarttheprocess.First,weknowtheYTMhastobelowerthanthecoupon
ratesincethebondisapremiumbond.Thatstillleavesalotofinterestratestocheck.Oneway
togetastartingpointistousethefollowingequation,whichwillgiveyouanapproximationof
theYTM:

ApproximateYTM=[Annualinterestpayment+(ParvaluePrice)/Yearstomaturity]/

[(Price+Parvalue)/2]

Solvingforthisproblem,weget:


ApproximateYTM=[$70+($38.50/9)]/[($1038.50+1000)/2]

ApproximateYTM=0.0645,or6.45%

ThisisnottheexactYTM,butitisclose,anditwillgiveyouaplacetostart.

5. Here we need to find the coupon rate of the bond. All we need to do is to set up the bond
pricingequationandsolveforthecouponpaymentasfollows:

P=$963=C(PVIFA7.5%,12)+$1000(PVIF7.5%,12)

Solvingforthecouponpayment,weget:

C=$70.22

Thecouponpaymentisthecouponratemultipliedbyparvalue.Usingthisrelationship,weget:

Couponrate=$70.22/$1000

Couponrate=0.0702,or7.02%

6. Tofindthepriceofthisbond,weneedtorealisethatthematurityofthebondis19years.The
bondwasissuedoneyearago,with20yearstomaturity,sothereare19yearsleftonthebond.
Also,thefacevalueis$200 000andthecouponsaresemiannual,soweneedtousethesemi
annualinterestrateandthenumberofsemiannualperiods.Thepriceofthebondis:

Thecouponis$200 000x6.1%/2=6100

P=$6100(PVIFA2.65%,38)+$200 000(PVIF2.65%,38)

P=$219 014.80

7. Here,wearefindingtheYTMofasemiannualcouponbond.Thebondpriceequationis:

P=$188 000=$6900(PVIFAR%,26)+$200 000(PVIFR%,26)

SincewecannotsolvetheequationdirectlyforR,usingaspreadsheet,afinancialcalculator,or
trialanderror,wefind:

R=3.818%

Sincethecouponpaymentsaresemiannual,thisisthesemiannualinterestrate.TheYTMis
theAPRofthebond,so:

YTM=2 3.818%

YTM=7.64%

8. Tofindthepriceofthebill,weneedtorealisethatthematurityofthebillis105days.Also,the
facevalueis$500 000.Thepriceofthebillis:

P=$500 000/(1+3.5%x105/365)

P=$495 015.94

9. Tofindthepriceofthisbill,weneedtorealisethatthematurityofthebillisnow50days(105
55).Thefacevalueremainsunchangedat$500 000Thepriceofthebillis:

P=$500 000/(1+3.25%x50/365)

P=$497 783.84

10. Here, we need to find the coupon rate of the bond. All we need to do is to set up the bond
pricingequationandsolveforthecouponpaymentasfollows:


P=$945=C(PVIFA4.2%,21)+$1000(PVIF4.2%,21)

Solvingforthecouponpayment,weget:

C=$38.01

Sincethisisthesemiannualpayment,theannualcouponpaymentis:

2$38.01=$76.02

Andthecouponrateisthecouponpaymentdividedbyparvalue,so:

Couponrate=$76.02/$1000

Couponrate=0.0760,or7.60%

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

R=r+h

Approximater=0.0410.016

Approximater=0.025,or2.50%

TheFisherEffectequation,whichshowstheexactrelationshipbetweennominalinterestrates,
realinterestrates,andinflation,is:

(1+R)=(1+r)(1+h)
 (1+0.041)=(1+r)(1+0.016)

Exactr=[(1+.041)/(1+0.016)]1

Exactr=0.0246,or2.46%

12. TheFisherEffectequation,whichshowstheexactrelationshipbetweennominalinterestrates,
realinterestrates,andinflation,is:

(1+R)=(1+r)(1+h)

R=(1+0.028)(1+0.034)1

R=0.0630,or6.30%

13. TheFisherEffectequation,whichshowstheexactrelationshipbetweennominalinterestrates,
realinterestrates,andinflation,is:

(1+R)=(1+r)(1+h)

h=[(1+0.14)/(1+0.10)]1

h=0.0364,or3.64%

14. TheFisherEffectequation,whichshowstheexactrelationshipbetweennominalinterestrates,
realinterestrates,andinflation,is:

(1+R)=(1+r)(1+h)

r=[(1+0.15)/(1.025)]1

r=0.1220,or12.20%

 Intermediatequestions(1730)

17. Firstworkoutthepricesofthetwobillsandthetracethroughthecashflows

Thepriceofthefirst60daybillis:

P=$500 000/(1+4.35%x60/365)

P=$496 450.04

Thepriceofthesecondbillis:

P=$500 000/(1+4.46%x60/365)

P=$496 360.93

Cashflowstodaythefirstdaythebillissold:inflowof$496 450.04

Cashflowsin60daystime:

Repayfirstbillandsellthesecondbill:

Outflowof$500 000andinflowof$496 360.93foranetcashflowof$3639.07

Cashflowinin120daystimerepaysecondbilloutflowof$500 000

18. Here,wearefindingthepriceofannualcouponbondsforvariousmaturitylengths.Thebond
priceequationis:

P=C(PVIFAR%,t)+$1000(PVIFR%,t)

X: P0 =$90(PVIFA7%,13)+$1000(PVIF7%,13) =$1167.15
 P1 =$90(PVIFA7%,12)+$1000(PVIF7%,12) =$1158.85

P3 =$90(PVIFA7%,10)+$1000(PVIF7%,10) =$1140.47

P8 =$90(PVIFA7%,5)+$1000(PVIF7%,5) =$1082.00

P12=$90(PVIFA7%,1)+$1000(PVIF7%,1) =$1018.69

P13 =$1000

Y: P0 =$70(PVIFA9%,13)+$1000(PVIF9%,13) =$850.26

P1 =$70(PVIFA9%,12)+$1000(PVIF9%,12) =$856.79

P3 =$70(PVIFA9%,10)+$1000(PVIF9%,10) =$871.65

P8 =$70(PVIFA9%,5)+$1000(PVIF9%,5) =$922.21

P12=$70(PVIFA9%,1)+$1000(PVIF9%,1) =$981.65

P13 =$1000

All else held equal, 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.Thisiscalledpulltopar.Inbothcases,thelargestpercentagepricechangesoccur
attheshortestmaturitylengths.

Also,noticethatthepriceofeachbondwhennotimeislefttomaturityistheparvalue,even
thoughthepurchaserwouldreceivetheparvalueplusthecouponpaymentimmediately.This
isbecausewecalculatethecleanpriceofthebond.

 MaturityandBondPrice
$1,300

$1,200

$1,100
BondPrice

$1,000
BondX
BondY

$900

$800

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

19. AnybondthatsellsatparhasaYTMequaltothecouponrate.Bothbondssellatpar,sothe
initialYTMonbothbondsisthecouponrate,7%.IftheYTMsuddenlyrisesto9%:

PBill =$35(PVIFA4.5%,6)+$1000(PVIF4.5%,6) =$948.42

PTed =$35(PVIFA4.5%,40)+$1000(PVIF4.5%,40) =$815.98

Thepercentagechangeinpriceiscalculatedas:

Percentagechangeinprice=(NewpriceOriginalprice)/Originalprice

PBill% =($948.421000)/$1000 =0.0516,or5.16%

PTed% =($815.981,000)/$1,000 =0.1840,or18.40%

IftheYTMsuddenlyfallsto5%:

PBill =$35(PVIFA2.5%,6)+$1000(PVIF2.5%,6) =$1055.08

PTed =$35(PVIFA2.5%,40)+$1000(PVIF2.5%,40) =$1251.03

PBill% =($1055.081000)/$1000=0.0551,or+5.51%

PTed% =($1251.031000)/$1000=0.2510,or+25.10%

Allthingsbeingequal,thelongerthematurityofabond,thegreaterisitspricesensitivityto
changesininterestrates.

 YTMandBondPrice
$2,500

$2,300

$2,100

$1,900

$1,700
BondPrice

$1,500
BondBill
$1,300 BondTed

$1,100

$900

$700

$500
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
YieldtoMaturity

20. Initially,ataYTMof8%,thepricesofthetwobondsare:

PJ =$20(PVIFA4%,20)+$1000(PVIF4%,20) =$728.19

PS =$70(PVIFA4%,20)+$1000(PVIF4%,20) =$1407.71

IftheYTMrisesfrom8%to10%:

PJ =$20(PVIFA5%,20)+$1000(PVIF5%,20)=$626.13

PS =$70(PVIFA5%,20)+$1000(PVIF5%,20) =$1249.24

Thepercentagechangeinpriceiscalculatedas:


Percentagechangeinprice=(NewpriceOriginalprice)/Originalprice

PJ% =($626.13728.19)/$728.19 =0.1402,or14.02%

PS% =($1249.241407.71)/$1407.71 =0.1126,or11.26%

IftheYTMdeclinesfrom8%to6%:

PJ =$20(PVIFA3%,20)+$1000(PVIF3%,20) =$851.23

PS =$70(PVIFA3%,20)+$1000(PVIF3%,20) =$1595.10

PJ% =($851.23728.19)/$728.19 =0.1690,or+16.90%

PS% =($1595.101407.71)/$1407.71 =0.1331,or+13.31%

Allthingsbeingequal,thelowerthecouponrateonabond,thegreaterisitspricesensitivityto
changesininterestrates.

22. Thebillpriceequationforthisbillis:

$492 950=$500 000/(1+r%x145/365)

R=3.6%=YTM

23. Thecompanyshouldsetthecouponrateonitsnewbondsequaltotherequiredreturnofthe
existing bond. The required return can be observed in the market by finding the YTM on
outstandingbondsofthecompany.So,theYTMonthebondscurrentlysoldinthemarketis:


P=$1125=$39(PVIFAR%,40)+$1000(PVIFR%,40)

Usingaspreadsheet,financialcalculator,ortrialanderror,wefind:

R=3.330%

Thisisthesemiannualinterestrate,sotheYTMis:

YTM=23.330%

YTM=6.66%

Thecouponrateshouldbesetto$66.60.