CHAPTER 6 VALUING BONDS

TEAM D (3)

Q.13
Consider the following bonds:

COUPON RATE (ANNUAL MATURITY

BOND
PAYMENTS) (YEARS)
A 0% 15
B 0% 10
C 4% 15
D 8% 10

a. What is the percentage change in the price of each bond if its yield to
maturity falls from 6% to 5%?
Bonds A and B are zero-coupon bonds, whereas C and D are coupon bonds. We
can compute the present value of the bonds (price of the bond) using the Excel
PV formula for a 100 $ bond.
The price of the bonds for YTD 5% and 6% are the following:

BOND PRICE
PAR
YTD YTD VARIATIO VARIATION
VALUE
5% 6% N %
$ Zero Coupon
$48.10 $41.73 -$6.38 -13.3%
100 bond
$ Zero Coupon
$61.39 $55.84 -$5.55 -9.0%
100 bond
$
$89.62 $80.58 -$9.04 -10.1% Discount
100
$ $123.1 $114.7
-$8.45 -6.9% Premium
100 7 2
Example of
NP RAT PM Excel
PV FV
ER E T formula
10
Given 10 5% 0
0
-
Solve =PV(5%,10,0,
$61.3
for PV 100)
9

NP RAT PM Excel
PV FV
ER E T formula
10
Given 15 6% 4
0
-
Solve =PV(6%,15,4,
$80.5
for PV 100)
8
application of Excel formula for bond

b. Which of the bonds A-D is most sensitive to a 1% drop in interest rates from
6% to 5% and why? Which bon is least sensitive?

VARIATION 6% --> 5%
BOND VARIATION
VARIATION
%
A $6.38 15.3%
B $5.55 9.9%
C $9.04 11.2%
D $8.45 7.4%

Bond A is the most sensitive to the variation, whereas bond D is the least.
For zero-coupon bonds there is no interest payments, and the face value is paid
at maturity. Thus, the total of the money invested (bond price) is affected by the
interest rate variation until maturity. The longer the maturity the higher the
affection and variation in the price. Long zero-coupon bonds are the most
sensitive to interest rate variations.
For coupon bonds, interest paid during the bond life offset the effect of interest
rate variation of the principal. Whereas in a zero-bond coupon rate 100% of the
price corresponds to the PV of the principal, in coupon rates (bond D) 50% of
bond price corresponds to PV of principal and 50% to PV of interest. Thus, high
coupon bonds are least sensitive to variations on the YTM.

Q. 24
Assume there are four default-free bonds with the following prices and future
cash flows:

YEARS
BOND PRICE
1 2 3
A -934.58
1,000 - -
B -881.66
- 1,000 -
C -1118.21
100 100 1,100
D -839.62
- - 1,000

Do these bonds present an arbitrage opportunity? If so, how would you talk
advantage of this opportunity? If not, why not?
By the Rule of One Price the value of a bond portfolio should be equal to the
combination of all the bonds of the portfolio. We can express bond C as a
combination of bonds A, B and D as follows:

CF timeline
0 3
1 2
A
-93.458 100 - -
B -88.166 - 100 -
=-83.962*11 =
D
923.58 - - =11*100
Sum (Bond
C) -1,105.21 100 100 1,100

The combined price of bonds A+B+C = 1,105.21 $, which should be the same
of price of bond C. But as bond C has a price of 1,118.21 $ there is a gap and an
arbitrage opportunity. Selling A+B+C for 1,105.21$ and buying bond C at
1,118.21$ will result in the same future cash flows but with an additional gain of
1,105.21 1,118.21 = 13 $.

Q. 25
Suppose you are given the following information about the default-free, coupon-
paying yield curve:

Marurity (years) 1 2 3 4
Coupon Rate (Annual 10.00 12.00
payments) 0.00% % 6.00% %
YTM 2.00% 3.91% 5.84% 5.78%

a. Use arbitrage to determine the yield to maturity of a two year, zero-coupon

bond.
A two year, zero-coupon bond ( C) can be also seen as the difference between a
2 year coupon bond (A) minus a 1 year coupon bond (B). We compute the PV of
the bonds A and B with the available data, and the price of bond C = Price bond
A Price bond B:

CF TIMELINE
0 1 2
10
A 2 year coupon bond -$1,115.05 0 1100
10
B 1 year bond -$98.04 0
C 2 year zero-coupon bond -$1,017.01 0 1100

To compute the YTM of bond C we use RATE formula in Excel:

NPE PM
RATE PV FV Excel formula
R T
- $
Given 2 $1,017. 0 1,000.0
01 0
Solve for 4.00 =RATE(2,0,0-
RATE % 1,017.01,1,000)

Yield To Maturity for a two year, zero-coupon bond is 4.00%

b. What is the zero-coupon yield curve for years 1 through 4?

Using the same methodology we can compute the zero-coupon YTM for 3 and 4
year bonds.

CF TIMELINE
0 1 2 3
A 1 year zero-coupon rate -$58.82 60
B 2 year zero-coupon bond -$55.47 60
C 3 year zero-coupon bond -$889.99 1060
D 3 year coupon bond -$1,004.29 60 60 1060
 NPE
RATE PV PMT FV Excel formula
R
- $
Given 3 $889.9 0 1,060.0
9 0
Solve for 6.00 =RATE(3,0,-
RATE % 889.99,1,060)

Yield To Maturity for a three year, zero-coupon bond is 6.00%

CF TIMELINE
0 1 2 3 4
A 1 year zero-coupon rate -$117.65 120
B 2 year zero-coupon bond -$110.95 120
C 3 year zero-coupon bond -$100.75 120
D 4 year coupon bond -$887.15 1120
E 4 year coupon bond -$1,216.50 120 120 120 1120

NPE
RATE PV PMT FV Excel formula
R
- $
Given 4 $887.1 0 1,120.0
5 0
Solve for 6.00 =RATE(4,0,-
RATE % 887.15,1,120)

Yield To Maturity for a four year, zero-coupon bond is 6.00%

The Zero-Coupon Yield Curve will be as follows:

ZERO-COUPON YIELD CURVE

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%
1 YEAR 2 YEAR 3 YEAR 4 YEAR
Q. 30
HMK Enterprises would like to raise $10 million to invest in capital expenditures.
The company plans to issue five-year bonds with a face value of $1,000 and a
coupon rate of 6.5% (annual payments). The following table summarized the
yield to maturity for five-year (annual pay) coupon corporate bonds of various
ratings:

Ratin
AAA AA A BBB BB
g
YTM 6.2% 6.3% 6.5% 6.9% 7.5%

a. Assuming the bonds will be rated AA, what will the price of the bonds be?
We compute the PV of the bonds with a interest rate of 6.3% (AA) as follows:

NPE
RATE PV PMT FV Excel formula
R
$
Given 5 6.3 % 65 1,000.0
0
-
Solve for =PV(6.3%,5,65,1,000
$1,008.
PV )
36

The price of the bond will be $ 1,008.36

b. How much total principal amount of these bonds must HMK issue to raise $10
million today, assuming the bonds are rated AA?
They should issue at least 9,918 bonds to receive $10 million in cash today.

c. What must the rating of the bonds be for them to sell at par?
The bonds are sold at par when the coupon rate is equal to the YTM rate. Thus to
be sold at par the rating should be A.

d. Suppose that when the bonds are issued, the price of each bond is $959.54.
What is the likely rating of the bonds? Are they junk bonds?
If we compute the YTM for that bond price we obtain 7.5% of rate, which
corresponds to a rating of BB and then it is considered junk bond.
 NPE
RATE PV PMT FV Excel formula
R
- $
Given 5 $959.5 65 1,000.0
4 0
Solve for 7.50 =RATE(5,65,-
RATE % 959.54,1,000)