4QQMN504 Principles of Finance

Seminar 3 Present and Future Values, Perpetuities and Annuities

Read Chapter 3 of Brealey et al., Principles of Corporate Finance, McGraw-Hill. After

reading Chapter 3, answer the following questions. The answers can be prepared in groups of
up to 4 students. (You can find the book in the King's College Library, online or in the
nearest Bookshop)

The submission file can be in word, excel, or power point and should be identified with
student names, k_number and tutorial class. The file name should start with the tutorial
number.

1. Bond prices and yields

A 10-year bond is issued with a face value of $1,000, paying interest of $60 a year. If
interest rates increase shortly after the bond is issued, what happens to the bond’s
a. remain the same
a) Coupon rate? b. When interest rates rise, existing bonds with
b) Price? lower coupon rates become less attractive to
c) Yield to maturity?investors compared to newly issued bonds with
higher coupon rates. As a result, the price of
existing bonds tends to decrease.
2. Bond prices and yields c. The yield to maturity for new investors may be
higher than the original coupon rate.
Construct some simple examples to illustrate your answers to the following:
a) If interest rates rise, do bond prices rise or fall?
b) If the bond yield to maturity is greater than the coupon, is the price of the bond is
greater or less than 100?
is
c) If the price of a bond exceeds 100, is the yield to maturity greater or less than the
coupon?
d) Do high-coupon bonds sell at higher or lower prices than low-coupon bonds?
e) If interest rates change, do the prices of high-coupon bonds change no
proportionately more than that of low-coupon bonds?
d. lower risk and less sensitive to the interest
rate risk, high-c bonds are more attractive to
3. Prices and yields investors due to relatively more higher or
stable income
In February 2012 Treasury 6¼s of 2030 offered a semi-annually compounded yield of
2.70%. Recognizing that coupons are paid semi-annually, calculate the bond’s price.
coupon payment: $3.125
y= 2.7%/2= 0.0135
4. Prices and yields n= 18y= 36 periods
Here are the prices of three bonds with 10‐year maturities:
Q3.
par value: $100
PV= (3.125/ 1.0135^36)+[3.125*(1/0.0135- 1/(0.0135*1.0135^36))]
PV of face value + PV of annuity of coupons
 highest YTM: A
Lowest: C
Longest duration: A
Shortest：C
Bond Coupon (%) Price (%)
A 2 81.62
B 4 98.39
C 8 133.42
Low-coupon bonds have longer durations (unless there is only one period to maturity) and
are therefore more volatile.
If coupons are paid annually, which bond offered the highest yield to maturity? Which
had the lowest? Which bonds had the longest and shortest durations?
5. Duration True or false? Explain.
F a) Longer‐maturity False.
bonds necessarily have longer durations.
Duration depends on the coupon as well as the maturity.
The longer a bond’s duration, the lower its volatility.
F b) False. Given the yield to maturity, volatility is proportional to duration.
T c) Other things equal, the lower the bond coupon, the higher its volatility.
F d) If interest rates rise, bond durations rise also.
A higher interest rate reduces the relative present value of distant principal repayments.
6. Duration
Calculate the durations and volatilities of securities A, B, and C. Their cash flows are
shown below. The interest rate is 8%.
Period 1 Period 2 Period 3
1.95 A 40 40 40 Total PV：103.08
2.59 B 20 20 120 130.93
2.74 C 10 10 110 105.15
列表： Y Ct PV(Ct) proportion of Total Value Proportion * Time V VA:1.80
7. Real interest rates
VB:2.39
nominal interest rate (R) VC: 2.54
The two‐year interest rate is 10% and the expected annual inflation rate is 5%.
a) What is the expected real interest rate? nominal-inflation= 5%
b) If the expected rate of inflation suddenly rises to 7%, what does Fisher’s theory say
about how the real interest rate will change? What about the nominal rate?
The real rate does not change. The nominal rate increases to
1.0476 × 1.07 – 1 = .1209 or 12.09%.
8. Inflation and Nominal Returns
Suppose the real rate is 4% and the inflation rate is 4.7%. What rate would you expect to
see on a Treasury bill? R=8.9%

9. Nominal and Real Returns

nominal interest rate
An investment offers a 15% total return over the coming year. You think the total real
return on this investment will be only 9%. What do you believe the inflation rate will be
over the next year? real r h=5.50%

10. Interest Rate Risk

 The percentage change in the price of a bond in
response to a change in interest rates can be
estimated using the modified duration
Percentage Change in Price=−Duration×Change
in Interest Rate
Both Bond Tony and Bond Peter have 10% coupons, make quarterly payments (that is,
four equal coupon payments per year), and are priced at par value £1,000. Bond Tony
has 3 years to maturity, whereas Bond Peter has 20 years to maturity. If interest rates
suddenly rise by 2%, what is percentage change in the price of Bond Tony? Of Bond
Peter? If rates were to suddenly fall by 2% instead, what would the percentage change in
the price of Bond Tony be then? Of Bond Peter? What does this problem tell you about
the interest rate risk of longer-term bonds?
percentage change in price= （new P - original P)/ original P
11. Interest Rate Risk
the semi-annual quoted rate is 8%/2 = 4%
Bond J is a 4% coupon bond. Bond K is a 12% coupon bond. Both bonds have nine years
to maturity, make semi-annual payments, and have a YTM of 8%. The par value of the
bonds is £1,000. If interest rates suddenly rise by 2%, what is percentage price change of
these bonds? What if rates suddenly fall by 2% instead? What does this problem tell you
about the interest rate risk of lower-coupon bonds?
Duration：J_6.5207;K_5.3561
12. Bond Prices versus Yields J：13.04% (+2%)/
K：10.7% (+2%)
a) What is the relationship between the price of a bond and its YTM? inverse/ negative r
b) Explain why some bonds sell at a premium over par value while other bonds sell at
a discount. What do you know about the relationship between the coupon rate and the
YTM for premium bonds? What about for discount bonds? For bonds selling at par
value?
c) What is the relationship between the current yield and YTM for premium bonds?
For discount bonds? For bonds selling at par value?

13. Interest on Zeros

Tesla plc needs to raise funds to finance a plant expansion, and it has decided to issue 20-
⽆票息
year zero coupon bonds to raise the money. The required return on the bonds will be
YTM= 12%. What will these bonds sell for at issuance? Assume semi-annual compounding. The
par value is £1,000.

14. Duration
The formula for the duration of a perpetual bond that makes an equal payment each year
in perpetuity is (1+yield)/yield. If each bond yields 5%, which has the longer duration—a
perpetual bond or a 15‐year zero‐coupon bond? What if the yield is 10%?
15. Nominal and real returns
Suppose that you buy a two‐year 8% bond at its face value.
a) What will be your nominal return over the two years if inflation is 3% in the first year
and 5% in the second? What will be your real return?
b) Now suppose that the bond is a TIPS. What will be your real and nominal returns?