HA 222 Practice problem set for chapter 7

7.1 Interpreting Bond Yields Is the yield to maturity on a bond the same thing as the required return? Is YTM the same thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par. Two years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond then? The YTM? The yield to maturity is the required rate of return on a bond expressed as a nominal annual interest rate. For noncallable bonds, the yield to maturity and required rate of return are interchangeable terms. Unlike YTM and required return, the coupon rate is not a return used as the interest rate in bond cash flow valuation, but is a fixed percentage of par over the life of the bond used to set the coupon payment amount. For the example given, the coupon rate on the bond is still 10 percent, and the YTM is 8 percent 7.2 Interpreting Bond Yields Supposing you buy a 7 percent coupon, 20-year bond today when its first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? Why? Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall. This is because the fixed coupon payments determined by the fixed coupon rate are not as valuable when interest rates rise - hence, the price of the bond decreases. NOTE: Most problems do not explicitly list a par value for bonds. Even though a bond can have any par value, in general, corporate bonds in the United States will have a par value of $1,000. We will use this par value in all problems unless a different par value is explicitly stated. 7.3 Bond Prices Carpenter, Inc., has 8 percent coupon bonds on the market that have 10 years left to maturity. The bonds make annual payments. If the YTM on these bonds is 9 percent, what is the current bond price? The price of any bond is the PV of the interest payment, plus the PV of the par value. Notice this problem assumes an annual coupon. The price of the bond will be: P = $80({1 [1/(1 + .09)]10} / .09) + $1,000[1 / (1 + .09)10] = $935.82 We would like to introduce shorthand notation here. Rather than write (or type, as the case may be) the entire equation for the PV of a lump sum, or the PVA equation, it is common to abbreviate the equations as: PVIFR,t = 1 / (1 + r)t which stands for Present Value Interest Factor PVIFA R,t = ({1 [1/(1 + r)]t } / r ) which stands for Present Value Interest Factor of an Annuity These abbreviations are short hand notation for the equations in which the interest rate and the number of periods are substituted into the equation and solved. We will use this shorthand notation in remainder of the solutions key.

7.4 Bond Yields Linebacker Co. has 7 percent coupon bonds on the market with nine years left to maturity. The bonds make annual payments. If the bond currently sells for $1,080, what is its YTM? Here we need to find the YTM of a bond. The equation for the bond price is: P = $1,080 = $70(PVIFA R,t) + $1,000(PVIF R,t) Notice the equation cannot be solved directly for R. Using a spreadsheet, a financial calculator, or trial and error, we find: R = YTM = 5.83% If you are using trial and error to find the YTM of the bond, you might be wondering how to pick an interest rate to start the process. First, we know the YTM has to be higher than the coupon rate since the bond is a discount bond. That still leaves a lot of interest rates to check. One way to get a starting point is to use the following equation, which will give you an approximation of the YTM: Approximate YTM = [Annual interest payment + (Price difference from par / Years to maturity)] /[(Price + Par value) / 2] Solving for this problem, we get: Approximate YTM = [$70 + ($80 / 9] / [($1,080 + 1,000) / 2] = 5.88% This is not the exact YTM, but it is close, and it will give you a place to start. 7.5 Coupon Rates Hawk Enterprises has bonds on the market making annual payments, with 16 years to maturity, and selling for $870. At this price, the bonds yield 7.5 percent. What must the coupon rate be on the bonds? Here we need to find the coupon rate of the bond. All we need to do is to set up the bond pricing equation and solve for the coupon payment as follows: P = $870 = C(PVIFA7.5%,16) + $1,000(PVIF7.5%,16) Solving for the coupon payment, we get: C = $60.78 The coupon payment is the coupon rate times par value. Using this relationship, we get: Coupon rate = $60.78 / $1,000 = .0608 or 6.08%

7.6 Bond Prices Cutler Co. issued 11-year bonds a year ago at a coupon rate of 7.8 percent. The bonds make semiannual payments. If the YTM on these bonds is 8.6 percent, what is the current bond price? To find the price of this bond, we need to realize that the maturity of the bond is 10 years. The bond was issued one year ago, with 11 years to maturity, so there are 10 years left on the bond.

Also, the coupons are semiannual, so we need to use the semiannual interest rate and the number of semiannual periods. The price of the bond is: P = $39(PVIFA4.3%,20) + $1,000(PVIF4.3%,20) = $947.05 7.7 Bond Yields Ngata Corp. issued 12-year bonds 2 years ago at a coupon rate of 9.2 percent. The bonds make semiannual payments. If these bonds currently sell for 104 percent of par value, what is the YTM? Here we are finding the YTM of a semiannual coupon bond. The bond price equation is: = $1,040 = $46(PVIFAR%,20) + $1,000(PVIF R%,20) Since we cannot solve the equation directly for R, using a spreadsheet, a financial calculator, or trial and error, we find: R = 4.298% Since the coupon payments are semiannual, this is the semiannual interest rate. The YTM is the APR of the bond, so: YTM = 2 4.298% = 8.60% 7.9 Calculating Real Rates of Return If Treasury bills are currently paying 8 percent and the inflation rate is 4.5 percent, what is the approximate real rate of interest? The exact real rate? The approximate relationship between nominal interest rates (R), real interest rates (r), and inflation (h) is: R=r+h Approximate r = .08 .045 =.035 or 3.50% The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is: (1 + R) = (1 + r)(1 + h) (1 + .08) = (1 + r)(1 + .045) Exact r = [(1 + .08) / (1 + .045)] 1 = .0335 or 3.35% 7.10 Inflation and Nominal Returns Suppose the real rate is 4 percent and the inflation rate is 5.8 percent. What rate would you expect to see on a Treasury bill? The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is: (1 + R) = (1 + r)(1 + h) R = (1 + .058)(1 + .04) 1 = .1003 or 10.03%

7.12 Nominal versus Real Returns Say you own an asset that had a total return last year of 14.2 percent. If the inflation rate last year was 5.3 percent, what was your real return? The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is: (1 + R) = (1 + r)(1 + h) r = [(1 + .142) / (1.053)] 1 = .0845 or 8.45% 7.15 Bond Price Movements Bond X is a premium bond making annual payments. The pays a 9 percent coupon, has a YTM of 7 percent, and has 13 years to maturity. Bond Y is a discounted bond making annual payments. This bond pays a 7 percent coupon, has a YTM of 9 percent, and also has 13 years to maturity. If interest rates remain unchanged, what do you expect the price of these bonds to be one year from now? In three years? In eight years? In 12 years? In 13 years? Whats going on here? Illustrate your answers by graphing bond prices versus time to maturity. Here we are finding the YTM of semiannual coupon bonds for various maturity lengths. The bond price equation is: P = C(PVIFAR%,t) + $1,000(PVIFR%,t) X: P0 = $90(PVIFA7%,13) + $1,000(PVIF7%,13) P1= $90(PVIFA7%,12) + $1,000(PVIF7%,12) P3= $90(PVIFA7%,10) + $1,000(PVIF7%,10) P8= $90(PVIFA7%,5) + $1,000(PVIF7%,5) P12 = $90(PVIFA7%,1) + $1,000(PVIF7%,1) P13 = $1,167.15 = $1,158.85 = $1,140.47 = $1,082.00 = $1,018.69 = $1,000

Y: P0 = $70(PVIFA9%,13) + $1,000(PVIF9%,13) = $850.26 P1= $70(PVIFA9%,12) + $1,000(PVIF9%,12) = $856.79 P3= $70(PVIFA9%,10) + $1,000(PVIF9%,10) = $871.65 P8= $70(PVIFA9%,5) + $1,000(PVIF9%,5) = $922.21 P12 = $70(PVIFA9%,1) + $1,000(PVIF9%,1) = $981.65 P13 = $1,000 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. This is called pull to par. In both cases, the largest percentage price changes occur at the shortest maturity lengths. Also, notice that the price of each bond when no time is left to maturity is the par value, even though the purchaser would receive the par value plus the coupon payment immediately. This is because we calculate the clean price of the bond. 7.16 Interest Rate Risk Both Bond Sam and Bond Dave have percent coupons, make semiannual payments, and are priced at par value. Bond Sam has 2 years to maturity, whereas Bond Dave has 15 years to maturity. If interest rates suddenly rise by 2 percent, what is the percentage change in the price of Bond Sam? Of Bond Dave? If rates were to suddenly fall by 2 percent instead, what would the percentage change in the price of Bond Sam be then? Of Bond Dave? Illustrate your answers by graphing bond prices versus YTM. What does this problem tell you about the interest rate risk of longer-term bonds?

Any bond that sells at par has a YTM equal to the coupon rate. Both bonds sell at par, so the initial YTM on both bonds is the coupon rate, 8 percent. If the YTM suddenly rises to 10 percent: PSam = $40(PVIFA5%,4) + $1,000(PVIF5%,4) = $964.54 PDave = $40(PVIFA5%,30) + $1,000(PVIF5%,30) = $846.28 The percentage change in price is calculated as: Percentage change in price = (New price Original price) / Original price PSam% = ($964.54 1,000) / $1,000 = 3.55% PDave% = ($846.28 1,000) / $1,000 = 15.37% If the YTM suddenly falls to 6 percent: PSam = $40(PVIFA3%,4) + $1,000(PVIF3%,4) = $1,037.17 PDave = $40(PVIFA3%,30) + $1,000(PVIF3%,30) = $1,196.00 PSam% = ($1,037.17 1,000) / $1,000 = + 3.72% PDave% = ($1,196.00 1,000) / $1,000 = + 19.60% All else the same, the longer the maturity of a bond, the greater is its price sensitivity to changes in interest rates. 7.17 Interest Rate Risk Bond J is a 4 percent coupon bond. Bond K is a 12 percent coupon bond. Both bonds have eight years to maturity, make semiannual payments, and have a YTM of 7 percent. If interest rates suddenly rise by 2 percent, what is the percentage price change of these bonds? What if rates suddenly fall by 2 percent instead? What does this problem tell you about the interest rate risk of lower coupon bonds? Initially, at a YTM of 7 percent, the prices of the two bonds are: PJ= $20(PVIFA3.5%,16) + $1,000(PVIF3.5%,16) = $818.59 PK= $60(PVIFA3.5%,16) + $1,000(PVIF3.5%,16) = $1,302.35 If the YTM rises from 7 percent to 9 percent: PJ= $20(PVIFA4.5%,16) + $1,000(PVIF4.5%,16) = $719.15 PK= $60(PVIFA4.5%,16) + $1,000(PVIF4.5%,16) = $1,168.51 The percentage change in price is calculated as: Percentage change in price = (New price Original price) / Original price PJ% = ($719.15 818.59) / $818.59 = 12.15% PK% = ($1,168.51 1,302.35) / $1,302.35 = 10.28% If the YTM declines from 7 percent to 5 percent: PJ = $20(PVIFA2.5%,16) + $1,000(PVIF2.5%,16) = $934.72 PK= $60(PVIFA2.5%,16) + $1,000(PVIF2.5%,16) = $1,456.93

PJ% = ($934.72 818.59) / $818.59 = + 14.19% PK% = ($1,456.93 1,302.35) / $1,302.35 = + 11.87% All else the same, the lower the coupon rate on a bond, the greater is its price sensitivity to changes in interest rates. 7.19 Bond Yields Giles Co. wants to issue new 20-year bonds for some much-needed expansion projects. The company currently has 7 percent coupon bonds on the market that sell for $1,062, make semiannual payments, and mature in 20 years. What coupon rate should the company set on its new bonds if it wants them to sell at par? The company should set the coupon rate on its new bonds equal to the required return. The required return can be observed in the market by finding the YTM on outstanding bonds of the company. So, the YTM on the bonds currently sold in the market is: P = $1,062 = $35(PVIFAR%,40) + $1,000(PVIFR%,40) Using a spreadsheet, financial calculator, or trial and error we find: R = 3.22% This is the semiannual interest rate, so the YTM is: YTM = 2 3.22% = 6.44% 7.22 Finding the Bond Maturity Jude Corp. has 9 percent coupon bonds making annual payments with a YTM of 6.3 percent. The current yield on these bonds is 7.1 percent. How many years do these bonds have left until they mature? To find the number of years to maturity for the bond, we need to find the price of the bond. Since we already have the coupon rate, we can use the bond price equation, and solve for the number of years to maturity. We are given the current yield of the bond, so we can calculate the price as: Current yield = .0710 = $90/P0 P0 = $90/.0710 = $1,267.61 Now that we have the price of the bond, the bond price equation is: P = $1,267.61 = $90[(1 (1/1.063)t ) / .063 ] + $1,000/1.063t We can solve this equation for t as follows: $1,267.61(1.063)t = $1,428.57 (1.063)t 1,428.57 + 1,000 428.57 = 160.96(1.063)t 2.6626 = 1.063t t = log 2.6626 / log 1.063 = 16.03 16 years The bond has 16 years to maturity. 7.27 Finding the Maturity Youve just found a 10 percent coupon bond on the market that sells for par value. What is the maturity on this bond? We found the maturity of a bond in Problem 22. However, in this case, the maturity is indeterminate. A bond selling at par can have any length of maturity. In other words, when we solve the bond pricing equation as we did in Problem 22, the number of periods can be any positive number.