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The Garraty Company has two bond issues outstanding.

Both bonds pay $100 annual interest plus


$1,000 at maturity. Bond L has a maturity of 15 years, and Bond S a maturity of 1 year. [7-5]
a.

What will be the value of each of these bonds when the going rate of interest is (1) 5%, (2)
8%, and (3) 12%? Assume that there is only one more interest payment to be made on Bond
S.

b.

Why does the longer-term (15-year) bond fluctuate more when interest rates change than
does the shorter-term bond (1-year)?

Some of the major considerations with bond questions are: (i)How many periods per year, that is, how
many times per year is interest paid?(ii) How many periods, n, are left until maturity? This is what
matters, not how long was the bond's life when it was first issued.(iii) Remember that i is the
periodic interest rate and refers to the level of interest rates in the economy.
The general equation for finding the value of a bond can be expressed as follows:
Using tables:- VB = Int(PVIFAi,n) + M(PVIFi,n)
Using the equation:- VB = Int[1 -

]+

M__

i( 1 + i)n ] (1 + i)n

[i

We will use each method to work an example, using 5% & 12%. Since they haven't indicated the
number of periods per year, we will assume it is 1, ie, coupon payments are made once per year.
Using tables, the value of the long bond @ 5% is; VL = 100(PVIFA5%,15) + 1000(PVIF5%,15)
= (100 x10.3797) + (1,000 x .4810)
=$1037.97 + $481.00 = $1,518.97
At 12%, VL = (100 x 6.8109) + (1,000 x .1827) = $681.09 + $182.70 = $863.79
The value of the short bond at 5%, VS = 100(PVIFA5%,1) + 1000(PVIF5%,1)
= (100 x .9524) + (1,000 x .9524)
= $95.24 + $952.40 = $1,047.64
At 12%, VS = (100 x .8929) + (1,000 x .8929) = $89.29 + $829.90 = $919.19
We are not surprised, are we, that for both the long and short bond, at 5% we have a premium bond and
at 12% we have a discount bond? The size of the discount and premium differs with the size of n, and
again we are not surprised, because the number of period remaining has a large effect on the amount of
value left on the bond.
Using the equation @ 5%, VL = 100[ 1 -

] + 1000 = (100 x 10.3754) + 481.02

[.05 .05(1.05)15]

(1.05)15

VL = $1,037.54 + $481.02 = $1,518.56


At 12%, VL = 100[ 1 -

] + 1000 = (100 x .9524) + 952.38 = $1,047.62

[.05 .05(1.05) ]

(1.05)

Practice using both methods to find the remaining values.

(b) Notice the changes in bond valuation between the long and short bonds as interest rates change.
Between 5% and 12%, the long bond values move from $1519.87 to $863.79, a difference of $656.08
(43%), while those for the short bond move from $1047.64 to $919.19, a difference of $128.45
(12.3%). Why? When interest rates rise, they have an adverse effect on all bonds, but have a greater
effect on on long bonds. This is because long bonds still have much (probably most) of their coupon
payments as well as the maturity values stretching far into the future and discount factors get more
severe as n gets larger. The long bond in this case has n = 15 whereas the short bond has n = 1. This
is called interest rate risk, and is more severe on longer bonds. When interest rates fall, the opposite
occurs. Both bonds are affected in that they both benefit, but the long bond benefits more. The short
bond will soon mature and the investor will be forced to re-invest his coupon payments and maturity
value at the new, lower rate now available. The long bond will not be maturing for another 15 years,
and so only the coupon payments have to reinvested at the lower rate. The maturity value (which is
most of the money) is locked away (at the old, higher rate) for another 15 years and will not be a
candidate for reinvestment. This is reinvestment rate risk, and brings a greater benefit to the long
bond.