Problem 10-41

The yield to maturity on one-year zero-coupon bonds is 8.9%. The yield to maturity on two-year
zero-coupon bonds is 9.9%.

a. What is the forward rate of interest for the second year? (Do not round intermediate
calculations. Round your answer to 2 decimal places.)

Forward rate of interest 10.91 ± 1%

%

b. If you believe in the expectations hypothesis, what is your best guess as to the expected value
of the short-term interest rate next year? (Do not round intermediate calculations. Round
your answer to 2 decimal places.)

Short-term interest rate 10.91 ± 1%

%

c. If you believe in the liquidity preference theory, is your best guess as to next year’s short-
term interest rate higher or lower than in (b)?

Lower

Explanation:

a.

The forward rate (f2) is the rate that makes the return from rolling over one-year bonds the same
as the return from investing in the two-year maturity bond and holding to maturity:
(1 + 8.9%) ×(1 + f2) = (1 + 9.9%)2 f2 = 0.1091 = 10.91%

b.

According to the expectations hypothesis, the forward rate equals the expected value of the
short-term interest rate next year, so the best guess would be 10.91%.

c.

According to the liquidity preference hypothesis, the forward rate exceeds the expected short-
term interest rate next year, so the best guess would be less than 10.91%.
Problem 10-17

A 20-year maturity bond with par value $1,000 makes semiannual coupon payments at a coupon
rate of 6%.

a. Find the bond equivalent and effective annual yield to maturity of the bond if the bond price is
$960. (Round your intermediate calculations to 4 decimal places. Round your answers to
2 decimal places.)

Bond equivalent yield to maturity 6.36 ± 1%

%

Effective annual yield to maturity 6.46 ± 1%

%

b. Find the bond equivalent and effective annual yield to maturity of the bond if the bond price is
$1,000. (Do not round intermediate calculations.Round your answers to 2 decimal places.)

Bond equivalent yield to maturity 6.00 ± 1%

%

Effective annual yield to maturity 6.09 ± 1%

%

c. Find the bond equivalent and effective annual yield to maturity of the bond if the bond price is
$1,040.(Round your intermediate calculations to 4 decimal places. Round your answers
to 2 decimal places.)

Bond equivalent yield to maturity 5.66 ± 1%

%

Effective annual yield to maturity 5.74 ± 1%

%
Explanation:

a.

Use the following inputs: n = 40, FV = 1,000, PV = –960, PMT = 30. We will find that the yield
to maturity on a semi-annual basis is 3.18%. This implies a bond equivalent yield to maturity of:
3.18% × 2 = 6.36%

Effective annual yield to maturity = (1.0318)2 – 1 = 0.0646 = 6.46%

b.

Since the bond is selling at par, the yield to maturity on a semi-annual basis is the same as the
semi-annual coupon, 3.0%. The bond equivalent yield to maturity is 6.00%.

Effective annual yield to maturity = (1.030)2 – 1 = .0609 = 6.09%

c.

Keeping other inputs unchanged but setting PV = –1,040, we find a bond equivalent yield to
maturity of 5.66%, or 2.83% on a semi-annual basis.

Effective annual yield to maturity = (1.0283)2 – 1 = .0574 = 5.74%

Problem 10-20

Fill in the table below for the following zero-coupon bonds, all of which have par values of $1,000.
(Do not round intermediate calculations. Round your answers to 2 decimal places.)

Price Maturity (years) Yield to Maturity

$ 420 20 4.38 ± 1% %

$ 520 20 3.30 ± 1% %

$ 520 10 6.65 ± 1% %
 $ 369.78 ± 1% 10 10.20 %

$ 465.25 ± 1% 10 7.80 %

$ 420 10.79 ± 1% 8.20 %

Explanation:

Remember that the convention is to use semi-annual periods:

Face value
Price of a zero-coupon bond =
(1 + Semiannual YTM)T

Bond equivalent YTM = Semi-annual YTM × 2

Bond
Maturity Maturity Semi - Annual Equivalent
Price (years) (half-years) YTM YTM

$ 420 20 40 2.19% 4.38%

$ 520 20 40 1.65% 3.30%

$ 520 10 20 3.32% 6.65%

$ 369.78 10 20 5.10% 10.20%

$ 465.25 10 20 3.90% 7.80%

$ 420 10.79 21.59 4.10% 8.20%

A newly issued 20-year maturity, zero-coupon bond is issued with a yield to maturity of 8.5% and
face value $1,000. Find the imputed interest income in the first, second, and last year of the bond's
life. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

Imputed Interest

First year 16.63 ± 1%

$

Second year 18.04 ± 1%

$
 Last year 78.34 ± 1%
$

Explanation:

The price schedule is as follows:

Remaining Constant Yield Value Imputed Interest

Year Maturity (T) 1,000/(1.085)T (Increase In Constant Yield Value)

0 (now) 20 years $ 195.62

1 19 212.24 195.62 − 212.24 = 16.63

2 18 230.28 230.28 − 212.24 = 18.04

19 1 921.66

20 0 1,000.00 1,000.00 − 921.66 = 78.34

Problem 10-34

A newly issued 10-year maturity, 4% coupon bond making annual coupon payments is sold to the
public at a price of $720. The bond will not be sold at the end of the year. The bond is treated as
an original-issue discount bond.

a. Calculate the constant yield price. (Do not round intermediate calculations. Round your
answer to 2 decimal places.)

Constant yield price 739.13 ± 0.5%

$

b. What will be an investor's taxable income from the bond over the coming year? (Do not
round intermediate calculations. Round your answer to 2 decimal places.)

Taxable income 59.13 ± 1%

$
Explanation:

a. & b.

The bond is issued at a price of $720. Therefore, its yield to maturity is 8.2130%. [n = 10; PV =
− 720; FV = 1,000; PMT = 40] Using the constant yield method, we can compute that its price in
one year (when maturity falls to 9 years) will be (at an unchanged yield) $739.13, representing an
increase of $19.13. Total taxable income is: $40 + $19.13 = $59.13.

You buy a(n) seven-year bond that has a 6.50% current yield and a 6.50% coupon (paid
annually). In one year, promised yields to maturity have risen to 7.50%. What is your holding-
period return? (Do not round intermediate calculations. Round your answer to 2 decimal
places.)

Holding-period 1.81 ± 0.1

return %
rev: 05_10_2013_QC_30493

Explanation:
The current yield and the annual coupon rate of 6.50% imply that the bond price was at par a year
ago.

Using a financial calculator, FV = 1,000, n = 6, PMT = 65.00, and i = 7.50 gives us a selling
price of $953.06 this year.

Holding period – $1,000 + $953.06 + $65.00

return = $1,000

= 0.0181 = 1.81%

A 8-year bond of a firm in severe financial distress has a coupon rate of 10% and sells for $950.
The firm is currently renegotiating the debt, and it appears that the lenders will allow the firm to
reduce coupon payments on the bond to one-half the originally contracted amount. The firm can
handle these lower payments. What are the stated and expected yields to maturity of the bonds?
The bond makes its coupon payments annually. (Do not round intermediate calculations.
Round your answers to 2 decimal places.)

Stated yield to maturity 10.97 ± 1%

%
Expected yield to maturity 5.80 ± 1%
%
Explanation:
Using financial calculator, n = 8; PV = –950; FV = 1,000; PMT = 100
The stated yield to maturity equals 10.97%.

Based on expected coupon payments of $50 annually, the expected yield to maturity is: 5.80%.

A 25-year maturity, 8.1% coupon bond paying coupons semiannually is callable in six years at a
call price of $1,105. The bond currently sells at a yield to maturity of 7.1% (3.55% per half-
year).

a. What is the yield to call? (Do not round intermediate calculations. Round your answer to
2 decimal places.)

Yield to call 7.12 ± 1%

%

b. What is the yield to call if the call price is only $1,055? (Do not round intermediate
calculations. Round your answer to 2 decimal places.)

Yield to call 6.49 ± 1%

%

c. What is the yield to call if the call price is $1,105 but the bond can be called in three years
instead of six years? (Do not round intermediate calculations. Round your answer to 2
decimal places.)

Yield to call 6.95 ± 1%

%

Explanation:
a.
The bond sells for $1,116.23 based on the 3.55% yield to maturity:

[n = 50; i = 3.55; FV = 1,000; PMT = 40.50]

Therefore, yield to call is 3.5596% semiannually, 7.12% annually:

[n = 12; PV = −1,116.23; FV = 1,105; PMT = 40.50]

b.
If the call price were $1,055, we would set FV = 1,055 and redo part (a) to find that yield to call
is 3.24720% semi-annually, 6.49% annually. With a lower call price, the yield to call is lower.

c.
Yield to call is 3.4746% semiannually, 6.95% annually:

[n = 6; PV = −1,116.23 ; FV = 1,105; PMT = 40.50]

Masters Corp. issues two bonds with 18-year maturities. Both bonds are callable at $1,060. The
first bond is issued at a deep discount with a coupon rate of 8% and a price of $580 to yield
14.9%. The second bond is issued at par value with a coupon rate of 8.15%.

a. What is the yield to maturity of the par bond? (Round your answer to 2 decimal places.)

Yield to maturity 8.15 ± 1%

%

If you expect rates to fall substantially in the next two years, which bond would you prefer to
b.
hold?
Bond with a coupon rate 8%

Explanation:
a.
The yield to maturity of the par bond equals its coupon rate, 8.15%.

b.
All else equal, the 4% coupon bond would be more attractive because its coupon rate is far
below current market yields, and its price is far below the call price. Therefore, if yields fall,
capital gains on the bond will not be limited by the call price. In contrast, the 8.15% coupon
bond can increase in value to at most $1,060, offering a maximum possible gain of only
6.0%. The disadvantage of the 8.15% coupon bond in terms of vulnerability to a call shows up
in its higher promised yield to maturity. If an investor expects rates to fall substantially, the 8%
bond offers a greater expected return.

Consider the following $1,000 par value zero-coupon bonds:

Years until Yield to

Bond
Maturity Maturity
A 1 4.0%
B 2 5.0
C 3 5.5
D 4 6.0

According to the expectations hypothesis, what is the market’s expectation of the one-year
interest rate three years from now? (Do not round intermediate calculations. Round your
answer to 2 decimal places.)
 Interest rate 7.51 ± 1%
%

Explanation:
Using a financial calculator, PV = 100, n = 3, PMT = 0, i = 5.5. Price of FV = 117.424.

Using a financial calculator, PV = 100, n = 4, PMT = 0, i = 6.0. Price or FV = 126.248.

Setting PV = –117.424, FV = 126.248, n = 1, PMT = 0. r = 7.51%.