CHAPTER 6

INTEREST RATES AND BOND

VALUATION
Solutions to questions and problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require
multiple steps. Due to space and readability constraints, when these intermediate steps are included
in this solutions manual, rounding may appear to have occurred. However, the final answer for each
problem is found without rounding during any step in the problem.

1. The yield to maturity (YTM) is the required rate of return on a bond expressed as a nominal
annual interest rate. For non-callable 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 it is a fixed percentage of face value 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 6%, and the YTM is 7%.

2. 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, we have adopted a par value of $1000. We will use this par value in
all problems unless a different par value is explicitly stated.

3. 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 = $42.5({1 – [1/(1 + 0.06)]8} / 0.06) + $1000[1 / (1 + 0.06)8]

P = $891.33

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

PVIFAR,t = ({1 – [1/(1 + R)]t } / R)

which stands for Present Value Interest Factor of an Annuity

These abbreviations are shorthand 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 the remainder of the solutions key. The bond price equation for this problem would
be:

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 P = $42.5(PVIFA6%,8) + $1000(PVIF6%,8)
P = $891.33

4. Here, we need to find the YTM of a bond. The equation for the bond price is:

P = $1 165.60 = $82.5(PVIFAR%,10) + $1000(PVIFR%,10)

Notice the equation cannot be solved directly for R. Using a spreadsheet, a financial calculator,
or trial and error, we find:

R = YTM = 6.00%

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 lower than the coupon rate
since the bond is a premium 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 + (Par value – Price) / Years to maturity] /
[(Price + Par value) / 2]

Solving for this problem, we get:

Approximate YTM = [$82.5 + (–$165.6 / 10)] / [($1165.6 + 1000) / 2]

Approximate YTM = 0.0609, or 6.09%

This is not the exact YTM, but it is close, and it will give you a place to start.

5. 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 = $952 = C(PVIFA6.5%,7) + $1000(PVIF6.5%,7)

Solving for the coupon payment, we get:

C = $66.1

The coupon payment is the coupon rate multiplied by par value. Using this relationship, we get:

Coupon rate = $66.1 / $1000

Coupon rate = 0.0661, or 6.61%

6. To find the price of this bond, we need to realise that the maturity of the bond is 19 years. The
bond was issued one year ago, with 20 years to maturity, so there are 19 years left on the bond.
Also, the face value is $100 000 and the coupons are semi-annual, so we need to use the semi-
annual interest rate and the number of semi-annual periods. The price of the bond is:

The coupon is $100 000 x 5.9%/2 = 2950

P = $2950(PVIFA2.375%,38) + $100 000(PVIF2.375%,38)
P = $114 287.7

7. Here, we are finding the YTM of a semi-annual coupon bond. The bond price equation is:

P = $1 425 000 = $43 125(PVIFAR%,22) + $1 500 000(PVIFR%,22)

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 Since we cannot solve the equation directly for R, using a spreadsheet, a financial calculator, or
trial and error, we find:

R = 3.19%

Since the coupon payments are semi-annual, this is the semi-annual interest rate. The YTM is the
APR of the bond, so:

YTM = 2  3.19% YTM = 6.38%

8. To find the price of the bill, we need to realise that the maturity of the bill is 120 days. Also, the
face value is $600 000. The price of the bill is:

P = $600 000 / (1 +3.25%x120/365)

P = $593 659.71

9. To find the price of this bill, we need to realise that the maturity of the bill is now 70 days (120–
50). The face value remains unchanged at $600 000 The price of the bill is:

P = $600 000 / (1 +3.65%x70/365)

P = $595 829.20

10. 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 = $967 = C(PVIFA4.05%,23) + $1000(PVIF4.05%,23)

Solving for the coupon payment, we get:

C = $38.3

Since this is the semi-annual payment, the annual coupon payment is:

2 × $38.3 = $76.6

And the coupon rate is the coupon payment divided by par value, so:

Coupon rate = $76.6 / $1000

Coupon rate = 0.0766, or 7.66%

11. The approximate relationship between nominal interest rates (R), real interest rates (r), and
inflation (h), is:

R=r+h

Approximate r = 0.0325 – 0.017

Approximate r = 0.0155, or 1.55%

The Fisher Effect equation, which shows the exact relationship between nominal interest rates,
real interest rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)
(1 + 0.0325) = (1 + r)(1 + 0.017)
Exact r = [(1 + .0325) / (1 + 0.017)] – 1
Exact r = 0.0152, or 1.52%

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12. The Fisher Effect equation, which shows the exact relationship between nominal interest rates,
real interest rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)

R = (1 + 0.026)(1 + 0.014) – 1
R = 0.0404, or 4.04%

13. The Fisher Effect equation, which shows the exact relationship between nominal interest rates,
real interest rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)

h = [(1 + 0.135) / (1 + 0.115)] – 1

h = 0.0179, or 1.79%

14. The Fisher Effect equation, which shows the exact relationship between nominal interest rates,
real interest rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)

r = [(1 + 0.16) / (1.021)] – 1

r = 0.1361, or 13.61%

17. First work out the prices of the two bills and the trace through the cash flows
The price of the first 60-day bill is:

P = $1 000 000 / (1 + 5.25% x 90/365)

P = $987 264.29

The price of the second bill is:

P = $1 000 000 / (1 + 5.36% x 90/365)

P = $986 971.97

Cash flows today the first day the bill is sold: inflow of $987 264.29

Cash flows in 90 days’ time:

Repay first bill and sell the second bill:
Outflow of $1 000 000 and inflow of $986 971.97 for a net cash flow of –$13 028.03

Cash flow in in 180 days’ time repay second bill out flow of $1000 000

18. Here, we are finding the price of annual coupon bonds for various maturity lengths. The bond
price equation is:

P = C(PVIFAR%,t) + $1000(PVIFR%,t)

X: P0 = $100(PVIFA8%,12) + $1000(PVIF8%,12) = $1150.72

P1 = $100(PVIFA8%,11) + $1000(PVIF8%,11) = $1142.78
P3 = $100(PVIFA8%,9) + $1000(PVIF8%,9) = $1124.94
P8 = $100(PVIFA8%,4) + $1000(PVIF8%,4) = $1066.24
P12 = = $1000

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 Y: P0 = $60(PVIFA8.5%,12) +
$1000(PVIF8.5%,12) = $816.38
P1 = $60(PVIFA8.5%,11) + $1000(PVIF8.5%,11) = $825.78
P3 = $60(PVIFA8.5%,9) + $1000(PVIF8.5%,9) = $847.02
P8 = $60(PVIFA8.5%,4) + $1000(PVIF8.5%,4) = $918.11
P12 = = $1000

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.

Maturity and Bond Price
 $1,300

 $1,200

 $1,100
Bond Price

 $1,000
Bond X
Bond Y

 $900

 $800

 $700
13 12 11 10 9 8 7 6 5 4 3 2 1 0
Maturity (Years)

19. 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, 6%. If the YTM suddenly rises to 9%:

PBill = $30(PVIFA4.5%,8) + $1000(PVIF4.5%,8) = $901.06

PTed = $30(PVIFA4.5%,50) + $1000(PVIF4.5%,50) = $703.57

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 The percentage change in price is calculated as:

Percentage change in price = (New price – Original price) / Original price

PBill% = ($901.06 – 1000) / $1000 = –0.0989, or –9.89%

PTed% = ($703.57 – 1000) / $1,000 = –0.2964, or –29.64%

If the YTM suddenly falls to 3%:

PBill = $30(PVIFA1.5%,8) + $1000(PVIF1.5%,8) = $1112.29

PTed = $30(PVIFA1.5%,50) + $1000(PVIF1.5%,50) = $1525.00

PBill% = ($1112.29 – 1000) / $1000 = 0.1123, or +11.23%

PTed% = ($1525.00 – 1000) / $1000 = 0.525, or +52.5%

All things being equal, the longer the maturity of a bond, the greater is its price sensitivity to
changes in interest rates.

YTM and Bond Price
 $2,500

 $2,300

 $2,100

 $1,900

 $1,700
Bond Price

 $1,500
Bond Bill
 $1,300 Bond Ted

 $1,100

 $900

 $700

 $500
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Yield to Maturity

20. Initially, at a YTM of 7.5%, the prices of the two bonds are:

PJ = $18.5(PVIFA3.75%,20) + $1000(PVIF3.75%,20) = $735.97

PS = $65(PVIFA3.75%,20) + $1000(PVIF3.75%,20) = $1382.15

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 If the YTM rises from 7.5% to 9%:

PJ = $18.5(PVIFA4.5%,20) + $1000(PVIF4.5%,20) = $655.29

PS = $65(PVIFA4.5%,20) + $1000(PVIF4.5%,20) = $1260.16

The percentage change in price is calculated as:

Percentage change in price = (New price – Original price) / Original price

PJ% = ($655.29 – 735.97) / $735.97 = –0.1096, or –10.96%

PS% = ($1260.16 – 1382.15) / $1382.15 = –0.0883, or –8.83%

If the YTM declines from 7.5% to 6%:

PJ = $18.5(PVIFA3%,20) + $1000(PVIF3%,20) = $828.91

PS = $65(PVIFA3%,20) + $1000(PVIF3%,20) = $1520.71

PJ% = ($828.91 – 735.97) / $735.97 = 0.1263, or +12.63%

PS% = ($1520.71 – 1382.15) / $1382.15 = 0.1002, or +10.02%

All things being equal, the lower the coupon rate on a bond, the greater is its price sensitivity to
changes in interest rates.

22. The bill price equation for this bill is:

$490 855 = $500 000 / (1 + r% x 136/365)

R = 5% = YTM

23. The company should set the coupon rate on its new bonds equal to the required return of the
existing bond. 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 = $1125 = $30.5(PVIFAR%,40) + $1000(PVIFR%,40)

Using a spreadsheet, financial calculator, or trial and error, we find:

R = 2.55%

This is the semi-annual interest rate, so the YTM is:

YTM = 2  2.55%
YTM = 5.10%

The coupon rate should be set to 5.10%.