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Chapter 06

Inputs are in Blue


Answers are in Red
NOTE: Some functions used in these spreadsheets may require that
the "Analysis ToolPak" or "Solver Add-In" be installed in Excel.
To install these, click on the Office button
then "Excel Options," "Add-Ins" and select
"Go." Check "Analysis ToolPak" and
"Solver Add-In," then click "OK."
2012, The McGraw-Hill Companies
Quiz 3
A bond with face value $1,000 has a current yield of 6% and a coupon rate of 8%.
What is the bonds price?
Face value 1,000.00 $
Current Yield 6%
Coupon Rate 8%
Solution:
Bond price 1,333.33 $ note: current yield =coupon payment/bond price
2012, The McGraw-Hill Companies
Quiz 4
A 6-year Circular File bond pays interest of $80 annually and sells for $950.
What are its coupon rate and yield to maturity?
Time 6.00 years
Interest 80.00
Price 950.00
Solution:
Coupon rate 8.00%
Using a financial calculator:
Yield to maturity 9.119%
2012, The McGraw-Hill Companies
2012, The McGraw-Hill Companies
Quiz 5
A 6-year Circular File bond pays interest of $80 annually and sells for $950.
If Circular File wants to issue a new 6-year bond at face value, what coupon rate must the bond offer?
Time 6.00 years
Interest 80.00
Price 950.00
Solution:
In order for the bond to sell at par, the coupon rate must equal the yield to maturity.
Using a financial calculator:
Yield to maturity 9.119%
Hence the coupon rate must be 9.119%
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Quiz 6
A bond has 8 years until maturity, a coupon rate of 8%, and sells for $1,100.
a. What is the current yield on the bond?
b. What is the yield to maturity?
Time 8.00 years
Coupon rate 8%
Price 1,100.00
Solution:
a. Current yield = 7.27% recall: current yield=coupon payment/bond price
put the kursor on the answer, klick on f
x
to see the functionargument =Rnta (perioder; betalning; nuvrde; slutvrde; typ)
b. Using a financial calculator:
Yield to maturity = 6.3662%
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recall: current yield=coupon payment/bond price
put the kursor on the answer, klick on f
x
to see the functionargument =Rnta (perioder; betalning; nuvrde; slutvrde; typ)
2012, The McGraw-Hill Companies
Quiz 7
General Matters outstanding bond issue has a coupon rate of 10%, and it sells at
a yield to maturity of 9.25%. The firm wishes to issue additional bonds to the public at face
value. What coupon rate must the new bonds offer in order to sell at face value?
Coupon rate 10%
YTM 9.25%
Solution:
Coupon rate on the new bonds = 9.25%
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Quiz 8
Refer to Table 6.1 (below). What is the current yield of the 8.75% 2020 maturity
bond? Why is this more than its yield to maturity?
Table 6.1
Maturity Coupon Bid Price Asked Price Asked Yield, %
2012 May 15 1.375 101:05 101:06 0.78
2013 May 15 3.625 106:31 107:01 1.23
2014 May 15 4.75 111:22 111:23 1.7
2020 May 15 8.75 144:17 144:19 3.44
2025 Aug 15 6.875 133:07 133:11 3.94
2030 May 15 6.25 128:25 128:27 4.12
2040 May 15 4.375 100:28 100:29 4.32
Coupon Rate 8.75%
Asked Price 144.00 19.00
Solution:
Current yield 6.05%
The current yield exceeds the yield to maturity on the bond because the bond is selling at a
premium. At maturity the holder of the bond will receive only the $1,000 face value, reducing
the total return on investment
2012, The McGraw-Hill Companies
Practice Problem 9
One bond has a coupon rate of 8%, another a coupon rate of 12%. Both bonds have 10-year
maturities and sell at a yield to maturity of 10%. If their yields to maturity next year are still 10%,
what is the rate of return on each bond? Does the higher coupon bond give a higher rate of return?
Coupon rate - bond 1 8.00%
Coupon rate - bond 2 12.00%
Maturity 10.00 years
YTM 10.00%
YTM next year 10.00%
Solution:
Using a financial calculator:
Bond 1:
Rate of return = 10.00%
Bond 2:
Rate of return = 10.00%
Both bonds provide the same rate of return.
2012, The McGraw-Hill Companies
Practice Problem 10
A bond has 8 years until maturity, a coupon rate of 8%, and sells for $1,100.
a. If this bond has a yield to maturity of 8% 1 year from now, what will its price be?
b. What will be the rate of return on the bond?
c. If the inflation rate during the year is 3%, what is the real rate of return on the bond?
Time 8.00 years
Coupon rate 8%
Price 1,100.00
YTM 8%
Inflation 3%
Solution:
a. Bond Price = 1,000.00 $
b. Bond Price 1,000.00 $
Rate of return = -1.82%
c. Rate of return -1.82%
Real return = -4.68%
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Practice Problem 11
A General Electric bond carries a coupon rate of 8%, has 9 years until maturity, and sells at a
yield to maturity of 7%.
a. What interest payments do bondholders receive each year?
b. At what price does the bond sell? (Assume annual interest payments.)
c. What will happen to the bond price if the yield to maturity falls to 6%?
Face value 1,000.00 $
Time 9.00 years
Coupon rate 8%
YTM 7%
YTM falls to 6%
Solution:
a. Annual interest payments = 80.00 $
b. Annual interest payments 80.00
Bond price = 1,065.15 $
c. Annual interest payments 80.00
Bond price if YTM falls to 6% = 1,136.03 $
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Practice Problem 12
A 30-year maturity bond with face value of $1,000 makes annual coupon payments and has a
coupon rate of 8%. What is the bonds yield to maturity if the bond is selling for
a. 900.00 $ ?
b. 1,000.00 $ ?
c. 1,100.00 $ ?
Face value 1,000.00 $
Time 30.00 years
Coupon rate 8%
Solution:
Using a financial calculator:
a. Yield to maturity = 8.971%
b. Yield to maturity = 8.000%
c. Yield to maturity = 7.180%
2012, The McGraw-Hill Companies
Practice Problem 13
A 30-year maturity bond with face value of $1,000 makes semi-annual coupon payments
and has a coupon rate of 8%. What is the bonds yield to maturity if the bond is selling for
a. 900.00 $ ?
b. 1,000.00 $ ?
c. 1,100.00 $ ?
Face value 1,000.00 $
Time 30.00 years
Coupon rate 8%
Solution:
Using a financial calculator:
a. Yield to maturity = 8.966%
b. Yield to maturity = 8.000%
c. Yield to maturity = 7.184%
2012, The McGraw-Hill Companies
Practice Problem 14
Fill in the table below for the following zero-coupon bonds. The face value of each bond
is $1,000.
Price
Maturity
(years)
Yield to
Maturity
300.00 $ 30.00
300.00 $ 8%
10.00 10%
Face value 1,000.00 $
Solution:
Price = $1,000/(1 + y )
maturity
Price
Maturity
(years)
Yield to
Maturity
300.00 $ 30.00 4.095%
300.00 $ 15.64 8.000%
385.54 $ 10.00 10.000%
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Practice Problem 15
Perpetual Life Corp. has issued consol bonds with coupon payments of $60. (Consols pay interest
forever and never mature. They are perpetuities.) If the required rate of return on these bonds at the
time they were issued was 6%, at what price were they sold to the public? If the required return
today is 10%, at what price do the consols sell?
Coupon Payments 60.00 $
Required rate of return
at the time of issue 6%
Current required rate of return 10%
Solution:
PV of perpetuity = coupon payment/rate of return
Present value = 1,000.00 $
If the required rate of return is 10%, the bond sells for:
Present value = 600.00 $
2012, The McGraw-Hill Companies
Practice Problem 16
Sure Tea Co. has issued 9% annual coupon bonds that are now selling at a yield to maturity of
10% and current yield of 9.8375%. What is the remaining maturity of these bonds?
Face value 1,000.00 $
Time 30.00 years
Coupon rate 9%
Yield to maturity 10%
Current yield 9.8375%
Solution:
Using a financial calculator:
Remaining maturity = 20.00 years
2012, The McGraw-Hill Companies
Practice Problem 17
Large Industries bonds sell for $1,065.15. The bond life is 9 years, and the yield to maturity is
7%. What must be the coupon rate on the bonds?
Face value 1,000.00 $
Bond price 1,065.15 $
Time 9.00 years
Yield to maturity 7%
Solution:
Using a financial calculator:
Coupon rate = 8.00%
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Practice Problem 18
a. Several years ago, Castles in the Sand, Inc., issued bonds at face value at a yield to maturity
of 7%. Now, with 8 years left until the maturity of the bonds, the company has run into hard
times and the yield to maturity on the bonds has increased to 15%. What has happened to the
price of the bond?
b. Suppose that investors believe that Castles can make good on the promised coupon payments,
but that the company will go bankrupt when the bond matures and the principal comes due.
The expectation is that investors will receive only 80% of face value at maturity. If they buy the
bond today, what yield to maturity do they expect to receive?
Face value 1,000.00 $
Yield to maturity 7%
Years left 8.00
Yield to maturity increased to 15%
Face value received by the investors 80%
Solution:
a. Price of bond = 641.01 $
b. Price of bond 641.01 $
Using a financial calculator:
Yield to maturity = 12.87%
2012, The McGraw-Hill Companies
Practice Problem 19
You buy an 8% coupon, 10-year maturity bond for $980. A year later, the bond price is $1,200.
a. What is the new yield to maturity on the bond?
b. What is your rate of return over the year?
Face value 1,000.00 $
Coupon rate 8%
Time 10.00 years
Bond price 980.00
Bond price a year later 1,200.00
Solution:
Using a financial calculator:
a. Yield to maturity = 5.165%
b. Rate of return = 30.61%
2012, The McGraw-Hill Companies
Practice Problem 20
You buy an 8% coupon, 20-year maturity bond when its yield to maturity is 9%. A year later, the
yield to maturity is 10%. What is your rate of return over the year?
Face value 1,000.00 $
Coupon rate 8%
Time 20.00 years bond price at t0
Yield to maturity 9% 908.71 kr
Yield to maturity next year 10% bond price at t1
832.70 kr
Solution: total return on investment on bond:
(coupon payment + P1-P0)/ P0
Using a financial calculator: 0.4388%
Rate of return = 0.44%
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total return on investment on bond:
2012, The McGraw-Hill Companies
Practice Problem 21
Consider three bonds with 8% coupon rates, all selling at face value. The short-term bond has a
maturity of 4 years, the intermediate-term bond has maturity 8 years, and the long-term bond has
maturity 30 years.
a. What will happen to the price of each bond if their yields increase to 9%?
b. What will happen to the price of each bond if their yields decrease to 7%?
Face value 1,000.00 $
Coupon rate 8%
Short term bond maturity 4.00 years
Intermediate-term bond maturity 8.00 years
Long-term bond maturity 30.00 years
Yield (a) 9%
Yield (b) 7%
Solution:
a., b.
Yield 4 Years 8 Years 30 Years
7% 1,033.87 $ 1,059.71 $ 1,124.09 $
8% 1,000.00 $ 1,000.00 $ 1,000.00 $
9% 967.60 $ 944.65 $ 897.26 $
Price of Each Bond at Different Yields to
Maturity
Maturity of Bond
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Practice Problem 22
A 2-year maturity bond with face value of $1,000 makes annual coupon payments of $80 and
is selling at face value. What will be the rate of return on the bond if its yield to maturity at
the end of the year is
a. 6% ?
b. 8% ?
c. 10% ?
Face value 1,000.00 $
Annual coupon 80.00 $
Time 2.00 years
Solution:
a. Rate of return = 9.89%
b. Rate of return = 8.00%
c. Rate of return = 6.18%
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Practice Problem 23
A bond that pays coupons annually is issued with a coupon rate of 4%, maturity of 30 years,
and a yield to maturity of 7%. What rate of return will be earned by an investor who purchases
the bond and holds it for 1 year if the bonds yield to maturity at the end of the year is 8%?
Face value 1,000.00 $
Coupon rate 4%
Time 30.00 years
Yield to maturity 7%
Yield to maturity by end of 1st year 8%
Solution:
Rate of return = -5.43%
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Practice Problem 24
A bonds credit rating provides a guide to its risk. Long-term bonds rated Aa currently offer yields to
maturity of 7.5%. A-rated bonds sell at yields of 7.8%. If a 10-year bond with a coupon rate of 7% is
downgraded by Moodys from Aa to A rating, what is the likely effect on the bond price?
Face value 1,000.00 $
Coupon rate 7%
Time 10.00 years
Current yield to maturity 7.5%
Yield of A rated bonds 8%
Solution:
The bonds yield to maturity will increase from 7.5% to 7.8% when the perceived default risk
Increases.
The bond price will fall:
Initial price = $965.68
New price = $945.83
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Practice Problem 25
Suppose that you buy a 1-year maturity bond for $1,000 that will pay you back $1,000 plus a
coupon payment of $70 at the end of the year. What real rate of return will you earn if the inflation
rate is
a. 2% ?
b. 4% ?
c. 6% ?
d. 8% ?
Face value 1,000.00 $
Annual coupon 70.00 $
Time 1.00 year
Solution:
a. Real rate of return = 4.902%
b. Real rate of return = 2.885%
c. Real rate of return = 0.9434%
d. Real rate of return = -0.926%
2012, The McGraw-Hill Companies
Practice Problem 26
Suppose that you buy a 1-year maturity bond for $1,000 that will pay you back $1,000 plus a
coupon payment of $70 at the end of the year and the inflation rate is
a. 2% ?
b. 4% ?
c. 6% ?
d. 8% ?
Now suppose that the bond is a TIPS (inflation-indexed) bond with a coupon rate of 4%.
What will the cash flow provided by the bond be for each of the four inflation rates? What will be
the real and nominal rates of return on the bond in each scenario?
Face value 1,000.00 $
Time 1.00 year
Coupon rate 4%
Solution:
The principal value of the bond will increase by the inflation rate, and since the coupon
is 4% of the principal, the coupon will also increase along with the general level of
prices. The total cash flow provided by the bond will be:
1,000 x (1 + inflation rate) + coupon rate x 1,000 x (1 + inflation rate)
Since the bond is purchased for face value, or $1,000, total dollar nominal return is
therefore the increase in the principal due to the inflation indexing, plus coupon income:
Income = ($1,000 x inflation rate) + [coupon rate x $1,000 x (1 + inflation rate)]
Finally: Nominal rate of return = income/$1,000
a. Nominal rate of return = 6.080%
Real rate of return = 4.00%
b. Nominal rate of return = 8.160%
Real rate of return = 4.00%
c. Nominal rate of return = 10.240%
Real rate of return = 4.00%
d. Nominal rate of return = 12.320%
Real rate of return = 4.00%
2012, The McGraw-Hill Companies
Practice Problem 27
Suppose that you buy a 1-year maturity bond for $1,000 that will pay you back $1,000 plus a
coupon payment of $70 at the end of the year and the inflation rate is
a. 2% ?
b. 4% ?
c. 6% ?
d. 8% ?
Now suppose the TIPS bond in the previous problem is a 2-year maturity bond.
What will be the bondholders cash flows in each year in each of the inflation scenarios?
Face value 1,000.00 $
Time 2.00 years
Coupon rate 4%
Solution:
Second-Year
Cash Flow
a. 40.80 $ 1,082.02 $
b. 41.60 $ 1,124.86 $
c. 42.40 $ 1,168.54 $
d. 43.20 $ 1,213.06 $
First-Year
Cash Flow
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Challenge Problem 28
Suppose interest rates increase from 8% to 9%. Which bond will suffer the greater percentage
decline in price: a 30-year bond paying annual coupons of 8% or a 30-year zero-coupon bond?
Face value 1,000.00 $
Interest rate 1 8.00%
Interest rate 2 9.00%
Time 30.00 years
Coupon 8.00%
Solution:
Coupon bond
Initial price = 1,000.00 $
New price = 897.26 $
Price decline % = 10.27%
Zero-coupon bond
Initial price = 99.38 $
New price = 75.37 $
Price decline % = 24.16%
Hence zero-coupon bond will suffer greater price decline.
2012, The McGraw-Hill Companies
Challenge Problem 29
Consider two 30-year maturity bonds. Bond A has a coupon rate of 4%, while bond B has a coupon
rate of 12%. Both bonds pay their coupons semiannually
a. Construct an Excel spreadsheet showing the prices of each of these bonds for yields to maturity
ranging from 2% to 15% at intervals of 1%. Column A should show the yield to maturity
(ranging from 2% to 15%), and columns B and C should compute the prices of the two
bonds (using Excels bond price function) at each interest rate.
b. In columns D and E, compute the percentage difference between the bond price and its value
when yield to maturity is 8%.
c. Plot the values in columns D and E as a function of the interest rate. Which bonds price is
proportionally more sensitive to interest rate changes?
Face value 100.00 $
Coupon rate bond A 4.00%
Coupon rate bond B 12.00%
Time 30.00 years
Yield to maturity 8.00% -144.96 kr
-119.69 kr
Solution: -100.00 kr
c.
a., b.
Yield Price A Price B % Diff. (8%) A % Diff. (8%) B
2% 144.96 324.78 165% 124%
3% 119.69 277.21 119% 91%
4% 100.00 239.04 83% 65%
5% 84.55 208.18 54% 43%
6% 72.32 183.03 32% 26%
7% 62.58 162.36 14% 12%
8% 54.75 145.25 0% 0%
9% 48.40 130.96 -12% -10%
10% 43.21 118.93 -21% -18%
11% 38.93 108.72 -29% -25%
12% 35.35 100.00 -35% -31%
13% 32.35 92.48 -41% -36%
14% 29.80 85.96 -46% -41%
15% 27.62 80.26 -50% -45%
The price of bond A is more sensitive to interest rate changes as reflected in the steeper curve.
-100%
-50%
0%
50%
100%
150%
200%
100.00
150.00
200.00
250.00
300.00
350.00
Price A
Price B
2012, The McGraw-Hill Companies
here you can see the higher the yield to maturity (IRR), the lower the bond price.
-
50.00
100.00
0% 5% 10% 15% 20%
2012, The McGraw-Hill Companies
Consider two 30-year maturity bonds. Bond A has a coupon rate of 4%, while bond B has a coupon
Construct an Excel spreadsheet showing the prices of each of these bonds for yields to maturity
In columns D and E, compute the percentage difference between the bond price and its value
The price of bond A is more sensitive to interest rate changes as reflected in the steeper curve.
% Diff. (8%) A % Diff. (8%) B
2012, The McGraw-Hill Companies
Challenge Problem 30
In Figure 6.7, we saw a plot of the yield curve on stripped Treasury bonds and pointed out that
bonds of different maturities may sell at different yields to maturity. In principle, when we are valuing
a stream of cash flows, each cash flow should be discounted by the yield appropriate to its particular
maturity. Suppose the yield curve on (zero-coupon) Treasury strips is as follows:
YTM
1 year 4.00%
2 5%
35 5.50%
610 6%
You wish to value a 10-year bond with a coupon rate of 10%, paid annually.
a. Set up an Excel spreadsheet to value each of the bonds annual cash flows using this table of
yields. Add up the present values of the bonds 10 cash flows to obtain the bond price.
b. What is the bonds yield to maturity? recall: Yield to maturity is internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price.
Face value 1,000.00 $
Coupon rate 10.00%
Time to maturity 10.00 years
Solution:
a., b.
Year YTM
Cash Flow
from Bond
PV of cash
flow
1 4.00% 100.00 96.15384615
2 5.00% 100.00 90.70294785
3 5.50% 100.00 85.16136642
4 5.50% 100.00 80.72167433
5 5.50% 100.00 76.51343538
6 6.00% 100.00 70.49605404
7 6.00% 100.00 66.50571136
8 6.00% 100.00 62.74123713
9 6.00% 100.00 59.18984635
10 6.00% 1,100.00 614.2342546
Bond price (PV) = 1302.420374
YTM (RATE) = 5.91%
Time to Maturity
2012, The McGraw-Hill Companies
recall: Yield to maturity is internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price.
stripped Treasury bonds:every coupon payment can be seen as a
zero coupon bond with time to maturity of the coupon payment.
2012, The McGraw-Hill Companies

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