Chapter 7 (13E) Bonds and Their Valuation: Answers To End-of-Chapter Questions

Chapter 7(13E)
Bonds and Their Valuation

Answers to End-of-Chapter Questions
7-1 From the corporations viewpoint, one important factor in establishing a sinking fund
is that its own bonds generally have a higher yield than do government bonds;
hence, the company saves more interest by retiring its own bonds than it could earn
by buying government bonds. This factor causes frms to favor the second
procedure. Investors also would prefer the annual retirement procedure if they
thought that interest rates were more likely to rise than to fall, but they would prefer
the government bond purchase program if they thought rates were likely to fall. In
addition, bondholders recognie that, under the government bond purchase scheme,
each bondholder would be entitled to a given amount of cash from the li!uidation of
the sinking fund if the frm should go into default, whereas under the annual
retirement plan, some of the holders would receive a cash beneft while others would
beneft only indirectly from the fact that there would be fewer bonds outstanding.
"n balance, investors seem to have little reason for choosing one method over
the other, while the annual retirement method is clearly more benefcial to the frm.
The conse!uence has been a pronounced trend toward annual retirement and away
from the accumulation scheme.
7-2 #es, the statement is true.
7-3 False. $hort%term bond prices are less sensitive than long%term bond prices to
interest rate changes because funds invested in short%term bonds can be reinvested
at the new interest rate sooner than funds tied up in long%term bonds.
For e&ample, consider two bonds, both with a '() annual coupon and a *',(((
par value. The only di+erence between them is their maturity. "ne bond is a '%year
bond, while the other is a ,(%year bond. -onsider the values of each at .), '(),
'.), and ,() interest rates.
'%year ,(%year
.) *',(/0.1, *',1,2.''
'() ',(((.(( ',(((.((
'.) 3.1.., 140.(2
,() 3'1.10 .'2.(/
5s you can see, the price of the ,(%year bond is much more volatile than the price of
the '%year bond.
7-4 The price of the bond will fall and its #T6 will rise if interest rates rise. If the bond
still has a long term to maturity, its #T6 will re7ect long%term rates. "f course, the
bonds price will be less a+ected by a change in interest rates if it has been
outstanding a long time and matures soon. 8hile this is true, it should be noted that
the #T6 will increase only for buyers who purchase the bond after the change in
interest rates and not for buyers who purchased previous to the change. If the bond
is purchased and held to maturity, the bondholders #T6 will not change, regardless
of what happens to interest rates. For e&ample, consider two bonds with an 4)
annual coupon and a *',((( par value. "ne bond has a .%year maturity, while the
other has a ,(%year maturity. If interest rates rise to '.) immediately after issue the
Chapter 7 Bonds and Their Valuation Answers and Solutions 1
! 2"13 Cen#a#e $earnin#% All &i#hts &eser'ed% (a) not *e +opied, s+anned, or dupli+ated, in whole or in part, e-+ept
for use as per.itted in a li+ense distri*uted with a +ertain produ+t or ser'i+e or otherwise on a password-prote+ted
we*site for +lassroo. use%
value of the .%year bond would be *01..2., while the value of the ,(%year bond
would be *.1'.4..
7-/ The yield to maturity can be viewed as the bonds promised rate of return, which is
the return that investors will receive if all of the promised payments are made.
9owever, the yield to maturity e!uals the expected rate of return only when :'; the
probability of default is ero and :,; the bond cannot be called. If there is some
default risk or the bond may be called, there is some chance that the promised
payments to maturity will not be received, in which case the calculated yield to
maturity will e&ceed the e&pected return.
7-0 If interest rates decline signifcantly, the values of callable bonds will not rise by as
much as those of bonds without the call provision. It is likely that the bonds would be
called by the issuer before maturity, so that the issuer can take advantage of the
new, lower rates.
7-7 5s an investor with a short investment horion, you would view the ,(%year Treasury
security as being more risky than the '%year Treasury security. If you bought the ,(%
year security, you would bear a considerable amount of price risk. $ince your
investment horion is only one year, you would have to sell the ,(%year security one
year from now, and the price you would receive for it would depend on what
happened to interest rates during that year. 9owever, if you purchased the '%year
security, you would be assured of receiving your principal at the end of that one year,
which is the '%year Treasurys maturity date.
7-1 a% If a bonds price increases, its #T6 decreases.
*% If a companys bonds are downgraded by the rating agencies, its #T6 increases.
+. If a change in the bankruptcy code made it more di<cult for bondholders to
receive payments in the event a frm declared bankruptcy, then the bonds #T6
would increase.
d% If the economy entered a recession, then the possibility of a frm defaulting on its
bond would increase; conse!uently, its #T6 would increase.
e% If a bond were to become subordinated to another debt issue, then the bonds
#T6 would increase.
7-2 If a company sold bonds when interest rates were relatively high and the issue is
callable, then the company could sell a new issue of low%yielding securities if and
when interest rates drop. The proceeds of the new issue would be used to retire the
high%rate issue, and thus reduce its interest e&pense. The call privilege is valuable to
the frm but detrimental to long%term investors, who will be forced to reinvest the
amount they receive at the new and lower rates.
7-1" 5 sinking fund provision facilitates the orderly retirement of the bond issue. 5lthough
sinking funds are designed to protect investors by ensuring that the bonds are retired
in an orderly fashion, sinking funds can work to the detriment of bondholders. "n
balance, however, bonds that have a sinking fund are regarded as being safer than
those without such a provision, so at the time they are issued sinking fund bonds
have lower coupon rates than otherwise similar bonds without sinking funds.
2 Answers and Solutions Chapter 7 Bonds and Their Valuation
7-11 5 call for sinking fund purposes is !uite di+erent from a refunding call. 5 sinking fund
call re!uires no call premium, and only a small percentage of the issue is normally
callable in a given year. 5 refunding call gives the issuer the right to call all the bond
issue for redemption. The call provision generally states that the issuer must pay the
bondholders an amount greater than the par value if they are called.
7-12 -onvertibles and bonds with warrants are o+ered with lower coupons than similarly%
rated straight bonds because both o+er investors the chance for capital gains as
compensation for the lower coupon rate. -onvertible bonds are e&changeable into
shares of common stock, at a f&ed price, at the option of the bondholder. "n the
other hand, bonds issued with warrants are options that permit the holder to buy
stock for a stated price, thereby providing a capital gain if the stocks price rises.
7-13 This statement is false. =&tremely strong companies can use debentures because
they simply do not need to put up property as security for their debt. >ebentures are
also issued by weak companies that have already pledged most of their assets as
collateral for mortgage loans. In this latter case, the debentures are !uite risky, and
that risk will be re7ected in their interest rates.
7-14 The yield spread between a corporate bond over a Treasury bond with the same
maturity re7ects both investors risk aversion and their optimism or pessimism
regarding the economy and corporate profts. If the economy appeared to be
heading into a recession, the spread should widen. The change in spread would be
even wider if a frms credit strength weakened.
7-1/ 5ssuming a bond issue is callable, the #T- is a better estimate of a bonds e&pected
return when interest rates are below an outstanding bonds coupon rate. The #T6 is
a better estimate of a bonds e&pected return when interest rates are e!ual or above
an outstanding bonds coupon rate.
3olutions to End-of-Chapter 4ro*le.s
7-1 8ith your fnancial calculator, enter the following?
@ A '(; IB#C A #T6 A 3); D6T A (.(4 ',((( A 4(; FE A '(((; DE A EF A G
DE A *32..4,.
7-2 EF A *34.; 6 A *',(((; Int A (.(0 *',((( A *0(.
a% @ A '(; DE A %34.; D6T A 0(; FE A '(((; #T6 A G
$olve for IB#C A #T6 A 0.,'.0) 0.,,).
*% @ A 0; IB#C A 0.,'.0; D6T A 0(; FE A '(((; DE A G
$olve for EF A DE A *344./1.
7-3 The problem asks you to fnd the price of a bond, given the following facts? @ A , 4 A
'1; IB#C A 4..B, A /.,.; D6T A :(.(3B,; H ',((( A /.; FE A '(((.
8ith a fnancial calculator, solve for DE A *',(,4.1(.
7-4 8ith your fnancial calculator, enter the following to fnd #T6?
@ A '( , A ,(; DE A %''((; D6T A (.(4B, ',((( A /(; FE A '(((; IB#C A #T6 A G
#T6 A 2.2') , A 1.1,).
8ith your fnancial calculator, enter the following to fnd #T-?
@ A . , A '(; DE A %''((; D6T A (.(4B, ',((( A /(; FE A '(.(; IB#C A #T- A G
#T- A 2.,/) , A 1./3).
$ince the #T- is less than the #T6, investors would e&pect the bonds to be called and to
earn the #T-.
7-/ a% '. .)? Fond I? Input @ A '., IB#C A ., D6T A '((, FE A '(((, DE A G, DE A
*',.'4.34.
Fond $? -hange @ A ', DE A G DE A *',(/0.1,.
,. 4)? Fond I? From Fond $ inputs, change @ A '. and IB#C A 4, DE A G, DE A
*','0'.'3.
Fond $? -hange @ A ', DE A G DE A *',('4..,.
2. ',)? Fond I? From Fond $ inputs, change @ A '. and IB#C A ',, DE A G, DE A
*412.04.
Fond $? -hange @ A ', DE A G DE A *34,.'/.
*% Think about a bond that matures in one month. Its present value is in7uenced
primarily by the maturity value, which will be received in only one month. =ven if
interest rates double, the price of the bond will still be close to *',(((. 5 '%year
bonds value would 7uctuate more than the one%month bonds value because of the
di+erence in the timing of receipts. 9owever, its value would still be fairly close to
*',((( even if interest rates doubled. 5 long%term bond paying semiannual coupons,
on the other hand, will be dominated by distant receipts, receipts that are multiplied
by 'B:' J rdB,;
t
, and if rd increases, these multipliers will decrease signifcantly.
5nother way to view this problem is from an opportunity point of view. 5 '%month
bond can be reinvested at the new rate very !uickly, and hence the opportunity to
invest at this new rate is not lost; however, the long%term bond locks in subnormal
returns for a long period of time.
7-0 a% Time #ears to 6aturity Drice of Fond - Drice of Fond K
t A ( / *',(',.03 * 132.(/
t A ' 2 ',('(.(, 0.3..0
t A , , ',((1.34 42,./3
t A 2 ' ',((2.1. 3',./'
t A / ( ',(((.(( ',(((.((
*%
7-7 Dercentage
Drice at 4) Drice at 0) -hange
'(%year, '() annual coupon *','2/.,( *',,'(.0' 1.0.)
'(%year ero /12.'3 .(4.2. 3.0.
.%year ero 14(..4 0',.33 /.01
2(%year ero 33.24 '2'.20 2,.'3
*'(( perpetuity ',,.(.(( ',/,4..0 '/.,3
7-1 The rate of return is appro&imately '..(2), found with a calculator using the following
inputs?
@ A 1; DE A %'(((; D6T A '/(; FE A '(3(; IB#C A G $olve for IB#C A '..(2).
>espite a '.) return on the bonds, investors are not likely to be happy that they were
called. Fecause if the bonds have been called, this indicates that interest rates have
fallen su<ciently that the #T- is less than the #T6. :$ince they were originally sold at
par, the #T6 at issuance A '/).; Cates are su<ciently low to Lustify the call. @ow
investors must reinvest their funds in a much lower interest rate environment.
Chapter 7 Bonds and Their Valuation Answers and Solutions /
7-2 a% EF A
=
+
+
+
@
' t
@
d
t
d
; r ' :
6
; r ' :
I@T
6 A *',(((. D6T A (.(3:*',(((; A *3(.
'. EF A *4,3? Input @ A /, DE A %4,3, D6T A 3(, FE A '(((, #T6 A IB#C A G IB#C A
'/.33).
,. EF A *','(/? -hange DE A %''(/, #T6 A IB#C A G IB#C A 1.(().
*% #es. 5t a price of *4,3, the yield to maturity, '.), is greater than your re!uired rate
of return of ',). If your re!uired rate of return were ',), you should be willing to
buy the bond at any price below *3(4.44.
7-1" a% $olving for #T6?
@ A 3, DE A %3('./(, D6T A 4(, FE A '(((
IB#C A #T6 A 3.13'').
*% The current yield is defned as the annual coupon payment divided by the current
price.
-# A *4(B*3('./( A 4.40.).
=&pected capital gains yield can be found as the di+erence between #T6 and the
current yield.
-M# A #T6 N -# A 3.13') N 4.40.) A (.4'1).
5lternatively, you can solve for the capital gains yield by frst fnding the e&pected
price ne&t year.
@ A 4, IB#C A 3.13'', D6T A 4(, FE A '(((
DE A %*3(4.01. EF A *3(4.01.
9ence, the capital gains yield is the percentage price appreciation over the ne&t year.
-M# A :D' N D(;BD( A :*3(4.01 N *3('./(;B*3('./( A (.4'1).
+% 5s rates change they will cause the end%of%year price to change and thus the realied
capital gains yield to change. 5s a result, the realied return to investors will di+er
from the #T6.
7-11 a% Osing a fnancial calculator, input the following to solve for #T6?
@ A '4, DE A %''((, D6T A 1(, FE A '(((, and solve for #T6 A IB#C A ..'2..).
9owever, this is a periodic rate. The nominal #T6 A ..'2..):,; A '(.,0(3)
'(.,0).
For the #T-, input the following?
@ A 4, DE A %''((, D6T A 1(, FE A '(1(, and solve for #T- A IB#C A ..(0/4).
9owever, this is a periodic rate. The nominal #T- A ..(0/4):,; A '(.'/3.)
'(.'.).
$o the bond is likely to be called, and investors are most likely to earn a '(.'.)
yield.
*% The current yield A *',(B*','(( A '(.3'). The current yield will remain the same;
however, if the bond is called the #T- re7ects the total return :rather than the #T6;
so the capital gains yield will be di+erent.
+% #T6 A -urrent yield J -apital gains :loss; yield
'(.,0) A '(.3') J -apital loss yield
%(.1/) A -apital loss yield.
This is the capital loss yield if the #T6 is e&pected.
9owever, based on our calculations in Dart a the total return e&pected would actually
be the #T- A '(.'.). $o, the e&pected capital loss yield A '(.'.) N '(.3') A
%(.01).
7-12 a% #ield to maturity :#T6;?
8ith a fnancial calculator, input @ A ,4, DE A %''1..0., D6T A 3., FE A '(((, IB#C A
G IB#C A #T6 A 4.(().
#ield to call :#T-;?
8ith a calculator, input @ A 2, DE A %''1..0., D6T A 3., FE A '(3(, IB#C A G IB#C A
#T- A 1.'').
*% Pnowledgeable investors would e&pect the return to be closer to 1.') than to 4). If
interest rates remain substantially lower than 3..), the company can be e&pected to
call the issue at the call date and to refund it with an issue having a coupon rate
lower than 3..).
+% If the bond had sold at a discount, this would imply that current interest rates are
above the coupon rate :i.e., interest rates have risen;. Therefore, the company
would not call the bonds, so the #T6 would be more relevant than the #T-.
7-13 The problem asks you to solve for the #T6 and Drice, given the following facts?
@ A . , A '(, D6T A 4(B, A /(, and FE A '(((. In order to solve for IB#C we need DE.
9owever, you are also given that the current yield is e!ual to 4.,'). Miven this
information, we can fnd DE :Drice;.
-urrent yieldA 5nnual interestB-urrent price
(.(4,' A *4(BDE
DE A *4(B(.(4,' A *30/./,.
@ow, solve for the #T6 with a fnancial calculator?
@ A '(, DE A %30/./,, D6T A /(, and FE A '(((. $olve for IB#C A #T6 A /.2,).
9owever, this is a periodic rate so the nominal #T6 A /.2,):,; A 4.1/).
7-14 a% The bond is selling at a large premium, which means that its coupon rate is much
higher than the going rate of interest. Therefore, the bond is likely to be calledQit is
more likely to be called than to remain outstanding until it matures. Therefore, the
likely life remaining on these bonds is . years :the time to call;.
*% $ince the bonds are likely to be called, they will probably provide a return e!ual to
the #T- rather than the #T6. $o, there is no point in calculating the #T6QLust
calculate the #T-. =nter these values?
@ A , . A '(, DE A %'2.2../, D6T A (.'/B, ',((( A 0(, FE A '(.(, and then
solve for #T- A IB#C.
The periodic rate is 2.,211), so the nominal #T- is , 2.,211) A 1./022)
1./0). This would be close to the going rate, and it is about what the frm would
have to pay on new bonds.
7-1/ First, we must fnd the amount of money we can e&pect to sell this bond for in . years.
This is found using the fact that in fve years, there will be '. years remaining until the
bond matures and that the e&pected #T6 for this bond at that time will be 4..).
@ A '., IB#C A 4.., D6T A 3(, FE A '(((
DE A %*',(/'..,. EF A *',(/'..,.
This is the value of the bond in . years. Therefore, we can solve for the ma&imum price
we would be willing to pay for this bond today, subLect to our re!uired rate of return of
'().
@ A ., IB#C A '(, D6T A 3(, FE A '(/'..,
DE A %*340.40. EF A *340.40.
#ou would be willing to pay up to *340.40 for this bond today.
7-10 Fefore you can solve for the price, we must fnd the appropriate semiannual rate at
which to evaluate this bond.
=5C A :' J I@"6B,;
,
N '
(.(4'1 A :' J I@"6B,;
,
N '
I@"6 A (.(4.
$emiannual interest rate A (.(4B, A (.(/ A /).
$olving for price?
@ A , '( A ,(, IB#C A /, D6T A (.(3B, ',((( A /., FE A '(((
DE A %*',(10.3.. EF A *',(10.3..
7-17 First, we must fnd the price Roan paid for this bond.
@ A '(, IB#C A 3.03, D6T A ''(, FE A '(((
DE A %*',(0..(,. EF A *',(0..(,.
Then to fnd the one%period return, we must fnd the sum of the change in price and the
coupon received divided by the starting price.
"ne%period return A
price Feginning
received -oupon price Feginning price =nding +
"ne%period return A :*',(1(./3 N *',(0..(, J *''(;B*',(0..(,
"ne%period return A 4.44).
7-11 a% 5ccording to Table 0.., the yields to maturity for 5nadarko Detroleums and -lear
-hannels bonds are 2.0/2) and 0.22(), respectively. $o, 5nadarko would need to
set a coupon of 2.0/2) to sell its bonds at par, while -lear -hannel would need to
set a coupon of 0.22().
*% -urrent investments in 5nadarko Detroleum and -lear -hannel would be e&pected to
earn returns e!ual to their e&pected present yields. The return is safer for 5nadarko
Detroleum, as these are investment%grade bonds. Iooking at the table, we see that
the 5nadarko Detroleum bonds are rated FFF% by $SD, while the -lear -hannel bonds
have an $SD rating of F.
7-12 a% Find the #T6 as follows?
@ A '(, DE A %''0., D6T A ''(, FE A '(((
IB#C A #T6 A 4.2.).
*% Find the #T-, if called in #ear . as follows?
@ A ., DE A %''0., D6T A ''(, FE A '(3(
IB#C A #T- A 4.'2).
+% The bonds are selling at a premium which indicates that interest rates have fallen
since the bonds were originally issued. 5ssuming that interest rates do not change
from the present level, investors would e&pect to earn the yield to call. :@ote that
the #T- is less than the #T6.;
d% $imilarly from above, #T- can be found, if called in each subse!uent year.
If called in #ear 1?
@ A 1, DE A %''0., D6T A ''(, FE A '(4(
IB#C A #T- A 4.,0).
@ A 0, DE A %''0., D6T A ''(, FE A '(0(
IB#C A #T- A 4.20).
@ A 4, DE A %''0., D6T A ''(, FE A '(1(
IB#C A #T- A 4./1).
@ A 3, DE A %''0., D6T A ''(, FE A '(.(
IB#C A #T- A 4..2).
5ccording to these calculations, the latest investors might e&pect a call of the bonds
is in #ear 1. This is the last year that the e&pected #T- will be less than the e&pected
#T6. 5t this time, the frm still fnds an advantage to calling the bonds, rather than
seeing them to maturity.
1" Answers and Solutions Chapter 7 Bonds and Their Valuation
Co.prehensi'e53preadsheet 4ro*le.
Note to Instructors:
The solution to this pro*le. is not pro'ided to students at the *a+6 of their te-t%
7nstru+tors +an a++ess the Excel 8le on the te-t*oo69s we*site or the 7nstru+tor9s
&esour+e C:%
7-2" a% Fond 5 is selling at a discount because its coupon rate :0); is less than the going
interest rate :#T6 A 3);. Fond F is selling at par because its coupon rate :3); is
e!ual to the going interest rate :#T6 A 3);. Fond - is selling at a premium
because its coupon rate :''); is greater than the going interest rate :#T6 A 3);.
*%
+%
d%
Chapter 7 Bonds and Their Valuation Comprehensive/Spreadsheet Problem 11
e%
'. ..42)
,. ..,1)
2. The bond is selling at a premium, which means that interest rates have
declined. If interest rates remain at current levels, then 6r. -lark should e&pect
the bond to be called. -onse!uently, he would earn the #T- not the #T6.
f%
Drice risk is the risk of a decline in a bondTs price due to an increase in interest
rates. Ceinvestment risk is the risk that a decline in interest rates will lead to a
decline in income from a bond portfolio.
Canking the bonds above in order from the most price risk to the least price risk?
'(%year bond with a ero coupon, '(%year bond with a 3) annual coupon, .%year
bond with a ero coupon, .%year bond with a 3) annual coupon, and a '%year bond
with a 3) annual coupon.
#ou can double check this ranking by calculating the prices of each bond at ,
di+erent interest rates, and then determining the percentage change in value.
:$ee calculations above.;
Canking the bonds above in order from the most reinvestment risk to the least
reinvestment risk? '%year bond with a 3) annual coupon, .%year bond with a 3)
annual coupon, .%year bond with a ero coupon, '(%year bond with a 3) coupon,
and '(%year bond with a ero coupon.
Cefer to Table 0., in te&t; however, the longer the maturity and the lower the
coupon rate of the bond, the lower the reinvestment risk of the bond.
12 Comprehensive/Spreadsheet Problem Chapter 7 Bonds and Their Valuation
#%
'.
Chapter 7 Bonds and Their Valuation Comprehensive/Spreadsheet Problem 13
,.
2.
14 Comprehensive/Spreadsheet Problem Chapter 7 Bonds and Their Valuation
7nte#rated Case
7-21
;estern (one) (ana#e.ent 7n+%
Bond Valuation
&o*ert Bla+6 and Carol Al'are< are 'i+e presidents of ;estern (one)
(ana#e.ent and +odire+tors of the +o.pan)9s pension fund
.ana#e.ent di'ision% A .a=or new +lient, the California $ea#ue of
Cities, has re>uested that ;estern present an in'est.ent se.inar to
the .a)ors of the represented +ities% Bla+6 and Al'are<, who will
.a6e the presentation, ha'e as6ed )ou to help the. *) answerin#
the followin# >uestions%
A% ;hat are a *ond9s 6e) features?
Answer @3how 37-1 throu#h 37-4 here%A Bere is a list of 6e)
features
1% 4ar or fa+e 'alue% ;e #enerall) assu.e a C1,""" par
'alue, *ut par +an *e an)thin#, and often C/,""" or .ore
is used% ;ith re#istered *onds, whi+h is what are issued
toda), if )ou *ou#ht C/",""" worth, that a.ount would
appear on the +erti8+ate%
2% Coupon rate% The dollar +oupon is the DrentE on the
.one) *orrowed, whi+h is #enerall) the par 'alue of the
*ond% The +oupon rate is the annual interest pa).ent
di'ided *) the par 'alue, and it is #enerall) set at the
'alue of r
d
on the da) the *ond is issued% To illustrate,
fro. Ta*le 7%/ the re>uired rate of return on F4 (or#an
Chase9s 2"21 *onds was 4%02/G when the) were issued,
so the +oupon rate was set at 4%02/G% 7f the +o.pan)
Chapter 7 Bonds and Their Valuation Interated Case 1/
were to Hoat a new issue toda), the +oupon rate would
*e set at the #oin# rate toda) (Fune 1", 2"11), whi+h
would *e around 4%/74GIthe JT( on these outstandin#
*onds%
3% (aturit)% This is the nu.*er of )ears until the *ond
.atures and the issuer .ust repa) the loan (return the
par 'alue)%
4% Call pro'ision% (ost *onds (e-+ept K%3% Treasur) *onds)
+an *e +alled and paid oL ahead of s+hedule after so.e
spe+i8ed D+all prote+tion period%E Menerall), the +all
pri+e is a*o'e the par 'alue *) so.e D+all pre.iu.%E ;e
will see that +o.panies tend to +all *onds if interest
rates de+line after the *onds were issued, so the) +an
refund the *onds with lower interest *onds% This is =ust
li6e ho.eowners re8nan+in# their .ort#a#es if
.ort#a#e interest rates de+line% The +all pre.iu. is li6e
the prepa).ent penalt) on a ho.e .ort#a#e%
/% 7ssue date% The date when the *ond issue was ori#inall)
sold%
0% :efault ris6 is inherent in all *onds e-+ept Treasur)
*ondsIwill the issuer ha'e the +ash to .a6e the
pro.ised pa).ents? Bonds are rated fro. AAA to :, and
the lower the ratin# the ris6ier the *ond, the hi#her its
default ris6 pre.iu., and, +onse>uentl), the hi#her its
re>uired rate of return, r
d
%
7% 3pe+ial features, su+h as +on'erti*ilit) and <ero +oupons,
will *e dis+ussed later%
10 Interated Case Chapter 7 Bonds and Their Valuation
B% ;hat are +all pro'isions and sin6in# fund pro'isions? :o
these pro'isions .a6e *onds .ore or less ris6)?
Answer @3how 37-/ throu#h 37-7 here%A A +all pro'ision is a
pro'ision in a *ond +ontra+t that #i'es the issuin#
+orporation the ri#ht to redee. the *onds under spe+i8ed
ter.s prior to the nor.al .aturit) date% The +all pro'ision
#enerall) states that the +o.pan) .ust pa) the
*ondholders an a.ount #reater than the par 'alue if the)
are +alled% The additional su., whi+h is +alled a +all
pre.iu., is t)pi+all) set e>ual to one )ear9s interest if the
*onds are +alled durin# the 8rst )ear, and the pre.iu.
de+lines at a +onstant rate of 7NT5N ea+h )ear thereafter%
A sin6in# fund pro'ision is a pro'ision in a *ond
+ontra+t that re>uires the issuer to retire a portion of the
*ond issue ea+h )ear% A sin6in# fund pro'ision fa+ilitates
the orderl) retire.ent of the *ond issue%
The +all pri'ile#e is 'alua*le to the 8r. *ut potentiall)
detri.ental to the in'estor, espe+iall) if the *onds were
issued in a period when interest rates were +)+li+all) hi#h%
Therefore, *onds with a +all pro'ision are ris6ier than those
without a +all pro'ision% A++ordin#l), the interest rate on a
new issue of +alla*le *onds will e-+eed that on a new issue
of non+alla*le *onds%
Althou#h sin6in# funds are desi#ned to prote+t
*ondholders *) ensurin# that an issue is retired in an orderl)
fashion, it .ust *e re+o#ni<ed that sin6in# funds will at ti.es
wor6 to the detri.ent of *ondholders% On *alan+e, howe'er,
*onds that pro'ide for a sin6in# fund are re#arded as *ein#
safer than those without su+h a pro'ision, so at the ti.e the)
Chapter 7 Bonds and Their Valuation Interated Case 17
are issued, sin6in# fund *onds ha'e lower +oupon rates than
otherwise si.ilar *onds without sin6in# funds%
C% Bow is the 'alue of an) asset whose 'alue is *ased on
e-pe+ted future +ash Hows deter.ined?
Answer @3how 37-1 throu#h 37-1" here%A
" 1 2 3 N
P P P P P
CQ
1
CQ
2
CQ
3
CQ
N
4V CQ
1
4V CQ
2
The 'alue of an asset is .erel) the present 'alue of its
e-pe+ted future +ash Hows
Value R 4V R
N
d
N
3
d
3
2
d
2
1
d
1
) r (1
CQ
%%%
) r 1 (
CQ
) r 1 (
CQ
) r 1 (
CQ
+
+ +
+
+
+
+
+
R
=
+
N
1 t
t
d
t
) r 1 (
CQ
%
7f the +ash Hows ha'e widel) 'ar)in# ris6, or if the )ield
+ur'e is not hori<ontal, whi+h si#ni8es that interest rates
are e-pe+ted to +han#e o'er the life of the +ash Hows, it
would *e lo#i+al for ea+h period9s +ash How to ha'e a
diLerent dis+ount rate% Bowe'er, it is 'er) diS+ult to .a6e
su+h ad=ust.entsT hen+e it is +o..on pra+ti+e to use a
sin#le dis+ount rate for all +ash Hows%
The dis+ount rate is the opportunit) +ost of +apitalT that
is, it is the rate of return that +ould *e o*tained on
alternati'e in'est.ents of si.ilar ris6% Thus, the dis+ount
rate depends pri.aril) on fa+tors dis+ussed in Chapter 7
r
i
R rU V 74 V (&4 V :&4V $4%
:% Bow is a *ond9s 'alue deter.ined? ;hat is the 'alue of a
1"-)ear, C1,""" par 'alue *ond with a 1"G annual +oupon if
its re>uired return is 1"G?
Answer @3how 37-11 and 37-12 here%A A *ond has a spe+i8+ +ash
How pattern +onsistin# of a strea. of +onstant interest
pa).ents plus the return of par at .aturit)% The annual
+oupon pa).ent is the +ash How 4(T R (Coupon rate)
(4ar 'alue) R "%1(C1,""") R C1""%
Qor a 1"-)ear, 1"G annual +oupon *ond, the *ond9s
'alue is found as follows
" 1 2 3 2 1"
P P P P P P
1"" 1"" 1"" 1"" 1""
2"%21 1,"""
12%04
%
%
%
31%//
31/ %/4
1,""" %""
E-pressed as an e>uation, we ha'e
C1,"""% C31/%/4 C31%// %%% 21 % 2" C
) r 1 (
""" , 1 C
) r (1
C1""
%%%
) r 1 (
1"" C
V
1"
d
1"
d
1
d
B
= + + + =
+
+
+
+ +
+
=
The *ond +onsists of a 1"-)ear, 1"G annuit) of C1"" per
)ear plus a C1,""" lu.p su. pa).ent at t R 1"
4V annuit) RC 014%40
4V .aturit) 'alue R 31/ %/4
Value of *ond RC1,""" %""
The .athe.ati+s of *ond 'aluation is pro#ra..ed into
8nan+ial +al+ulators that do the operation in one step, so
1"G
the eas) wa) to sol'e *ond 'aluation pro*le.s is with a
8nan+ial +al+ulator% 7nput N R 1", r
d
R 75J& R 1", 4(T R
1"", and QV R 1""", and then press 4V to 8nd the *ond9s
'alue, C1,"""% 3preadsheets +an also *e used to 8nd the
*ond9s 'alue%
E% (1) ;hat is the 'alue of a 13G +oupon *ond that is otherwise
identi+al to the *ond des+ri*ed in 4art :? ;ould we now
ha'e a dis+ount or a pre.iu. *ond?
Answer @3how 37-13 here%A ;ith a 8nan+ial +al+ulator, =ust +han#e
the 'alue of 4(T fro. C1"" to C13", and press the 4V
*utton to deter.ine the 'alue of the *ond
4ri+e of 13G +oupon *ond R C1,114%34%
7n a situation li6e this, when the +oupon rate e-+eeds the
*ond9s re>uired rate of return, r
d
, the *ond9s 'alue rises
a*o'e par, and sells at a pre.iu.%
E% (2) ;hat is the 'alue of a 7G +oupon *ond with these
+hara+teristi+s? ;ould we now ha'e a dis+ount or pre.iu.
*ond?
Answer @3how 37-14 here%A 7n the se+ond situation, where the
+oupon rate (7G) is *elow the *ond9s re>uired return (1"G),
the pri+e of the *ond falls *elow par% Fust +han#e 4(T to
C7"% ;e see that the 1"-)ear *ond9s 'alue falls to C11/%00%
Thus, when the +oupon rate is *elow the re>uired rate
of return, the *onds9 'alue falls *elow par, or sells at a
dis+ount% Qurther, the lon#er the .aturit), the #reater the
pri+e eLe+t of an) #i'en interest rate +han#e%
2" Interated Case Chapter 7 Bonds and Their Valuation
E% (3) ;hat would happen to the 'alues of the 7G, 1"G, and 13G
+oupon *onds o'er ti.e if the re>uired return re.ained at
1"G? (Bint ;ith a 8nan+ial +al+ulator, enter 4(T, 75J&, QV,
and NT then +han#e (o'erride) N to see what happens to the
4V as it approa+hes .aturit)%)
Answer @3how 37-1/ and 37-10 here%A Assu.in# that interest rates
re.ain +onstant (at 1"G), we +ould 8nd the *ond9s 'alue as
ti.e passes, and as the .aturit) date approa+hes% 7f we
then plotted the data, we would 8nd the situation shown
*elow
At .aturit), the 'alue of an) *ond .ust e>ual its par 'alue
(plus a++rued interest)% Therefore, if interest rates, hen+e
the re>uired rate of return, re.ain +onstant o'er ti.e, then
a *ond9s 'alue .ust .o'e toward its par 'alue as the
.aturit) date approa+hes, so the 'alue of a pre.iu. *ond
de+reases to C1,""", and the 'alue of a dis+ount *ond
in+reases to C1,""" (*arrin# default)%
Q% (1) ;hat is the )ield to .aturit) on a 1"-)ear, 2G, annual
+oupon, C1,""" par 'alue *ond that sells for C117%""? That
sells for C1,134%2"? ;hat does the fa+t that it sells at a
dis+ount or at a pre.iu. tell )ou a*out the relationship
*etween r
d
and the +oupon rate?
Answer @3how 37-17 throu#h 37-12 here%A The )ield to .aturit)
(JT() is the dis+ount rate that e>uates the present 'alue of
a *ond9s +ash Hows to its pri+e% 7n other words, it is the
pro.ised rate of return on the *ond% (Note that the
e-pe+ted rate of return is less than the JT( if so.e
pro*a*ilit) of default e-ists%) On a ti.e line, we ha'e the
followin# situation when the *ond sells for C117
" 1 2 1"
P P P P
2" 2" 2"
4V
1
1,"""
%
%
%
4V
1"
4V
(
3u. R 4V R 117
;e want to 8nd r
d
in this e>uation
V
B
R 4V R
N
d
N
d
1
d
) r 1 (
(
) r (1
7NT
%%%
) r 1 (
7NT
+
+
+
+ +
+
%
;e 6now N R 1", 4V R -117, 4(T R 2", and QV R 1""", so
we ha'e an e>uation with one un6nown, r
d
% ;e +an sol'e
for r
d
*) enterin# the 6nown data into a 8nan+ial +al+ulator
and then pressin# the 75J& *utton% The JT( is found to *e
1"%21G%
;e +an tell fro. the *ond9s pri+e, e'en *efore we *e#in
the +al+ulations, that the JT( .ust *e a*o'e the 2G
+oupon rate% ;e 6now this *e+ause the *ond is sellin# at a
dis+ount, and dis+ount *onds alwa)s ha'e r
d
W +oupon rate%
r
d
R ?
7f the *ond were pri+ed at C1,134%2", then it would *e
sellin# at a pre.iu.% 7n that +ase, it .ust ha'e a JT( that
is *elow the 2G +oupon rate, *e+ause all pre.iu. *onds
.ust ha'e +oupons that e-+eed the #oin# interest rate%
Moin# throu#h the sa.e pro+edures as *eforeIplu##in#
the appropriate 'alues into a 8nan+ial +al+ulator and then
pressin# the 75J& *utton, we 8nd that at a pri+e of
C1,134%2", r
d
R JT( R 7%"1G%
Q% (2) ;hat are the total return, the +urrent )ield, and the +apital
#ains )ield for the dis+ount *ond? Assu.e that it is held to
.aturit) and the +o.pan) does not default on it% (Bint
&efer to Qootnote 7 for the de8nition of the +urrent )ield
and to Ta*le 7%1%)
Answer @3how 37-2" throu#h 37-22 here%A The +urrent )ield is
de8ned as follows
Current )ield R
*ond the of pri+e Current
pa).ent interest +oupon Annual
%
The +apital #ains )ield is de8ned as follows
Capital #ains )ield R
pri+e )ear - of - Be#innin#
pri+e s *ondX in +han#e E-pe+ted
%
The total e-pe+ted return is the su. of the e-pe+ted
+urrent )ield and the e-pe+ted +apital #ains )ield
return total
E-pe+ted
R
)ield #ains
+apital E-pe+ted
eld +urrent )i
E-pe+ted
+ %
The ter. )ield to .aturit), or JT(, is often used in
dis+ussin# *onds% 7t is si.pl) the e-pe+ted total return
(assu.in# no default ris6 and the *onds are not +alled), so
d
r Y
R e-pe+ted total return R e-pe+ted JT(%
&e+all also that se+urities ha'e re>uired returns, r
d
,
whi+h depend on a nu.*er of fa+tors
&e>uired return R r
d
R rU V 74 V $4 V (&4 V :&4%
;e 6now that (1) se+urit) .ar6ets are nor.all) in
e>uili*riu., and (2) that for e>uili*riu. to e-ist, the
e-pe+ted return,
d
r Y
R JT(, as seen *) the .ar#inal
in'estor, .ust *e e>ual to the re>uired return, r
d
% 7f that
e>ualit) does not hold, then *u)in# and sellin# will o++ur
until it does hold, and e>uili*riu. is esta*lished%
Therefore, for the .ar#inal in'estor
d
r Y
R JT( R r
d
%
Qor our 2G +oupon, 1"-)ear *ond sellin# at a pri+e of C117
with a JT( of 1"%21G, the +urrent )ield is
Current )ield R

C117
C2"

R "%1"1/ R 1"%1/G%
Znowin# the +urrent )ield and the total return, we +an 8nd
the +apital #ains )ield
JT( R Current )ield V Capital #ains )ield
and
Capital #ains )ield R JT( [ Current )ield
R 1"%21G [ 1"%1/G R "%70G%
The +apital #ains )ield +al+ulation +an *e +he+6ed *) as6in#
this >uestion D;hat is the e-pe+ted 'alue of the *ond 1
)ear fro. now, assu.in# that interest rates re.ain at
+urrent le'els?E This is the sa.e as as6in#, D;hat is the
'alue of a 2-)ear, 2G annual +oupon *ond if its JT( (its
re>uired rate of return) is 1"%21G?E The answer, usin# the
*ond 'aluation fun+tion of a +al+ulator, is C123%17% ;ith this
data, we +an now +al+ulate the *ond9s +apital #ains )ield as
follows
Capital #ains )ield R
" " 1
B B B
)5V V V (
R (C123%17 [ C117)5C117 R "%""77 R
"%77G,
whi+h a#rees with our earlier +al+ulation (e-+ept for
roundin#)% ;hen the *ond is sellin# for C1,134%2" and
pro'idin# a total return of r
d
R JT( R 7%"1G, we ha'e this
situation
Current )ield R C2"5C1,134%2" R 7%24G
and
Capital #ains )ield R 7%"1G [ 7%24G R -"%10G%
The *ond pro'ides a +urrent )ield that e-+eeds the total
return, *ut a pur+haser would in+ur a s.all +apital loss
ea+h )ear, and this loss would e-a+tl) oLset the e-+ess
+urrent )ield and for+e the total return to e>ual the
re>uired rate%
M% ;hat is pri+e ris6? ;hi+h has .ore pri+e ris6, an annual
pa).ent 1-)ear *ond or a 1"-)ear *ond? ;h)?
Answer @3how 37-23 and 37-24 here%A 4ri+e ris6 is the ris6 that a
*ond will lose 'alue as the result of an in+rease in interest
rates% The ta*le *elow #i'es 'alues for a 1"G, annual
+oupon *ond at diLerent 'alues of r
d

(aturit)
r
d
1-Jear Chan#e 1"-Jear Chan#e
/G C1,"41 C1,310
1" 1,""" 1,"""
1/ 2/0 742
A /G in+rease in r
d
+auses the 'alue of the 1-)ear *ond to
de+line *) onl) 4%4G, *ut the 1"-)ear *ond de+lines in 'alue
*) .ore than 2/G% Thus, the 1"-)ear *ond has .ore pri+e
ris6%
The #raph a*o'e shows the relationship *etween *ond
'alues and interest rates for a 1"G, annual +oupon *ond
with diLerent .aturities% The lon#er the .aturit), the
#reater the +han#e in 'alue for a #i'en +han#e in interest
rates, r
d
%
B% ;hat is rein'est.ent ris6? ;hi+h has .ore rein'est.ent
ris6, a 1-)ear *ond or a 1"-)ear *ond?
Answer @3how 37-2/ throu#h 37-27 here%A &ein'est.ent ris6 is
de8ned as the ris6 that +ash Hows (interest plus prin+ipal
repa).ents) will ha'e to *e rein'ested in the future at
rates lower than toda)9s rate% To illustrate, suppose )ou
V4%1G
-4%4G
V31%0G
-2/%1G
=ust won the lotter) and now ha'e C/"","""% Jou plan to
in'est the .one) and then to li'e on the in+o.e fro. )our
in'est.ents% 3uppose )ou *u) a 1-)ear *ond with a 1"G
JT(% Jour in+o.e will *e C/",""" durin# the 8rst )ear%
Then, after 1 )ear, )ou will re+ei'e )our C/"",""" when the
*ond .atures, and )ou will then ha'e to rein'est this
a.ount% 7f rates ha'e fallen to 3G, then )our in+o.e will
fall fro. C/",""" to C1/,"""% On the other hand, had )ou
*ou#ht 3"-)ear *onds that )ielded 1"G, )our in+o.e would
ha'e re.ained +onstant at C/",""" per )ear% Clearl),
*u)in# *onds that ha'e short .aturities +arries
rein'est.ent ris6% Note that lon#-ter. *onds also ha'e
rein'est.ent ris6, *ut the ris6 applies onl) to the +oupon
pa).ents, and not to the prin+ipal a.ount% 3in+e the
+oupon pa).ents are si#ni8+antl) less than the prin+ipal
a.ount, the rein'est.ent ris6 on a lon#-ter. *ond is
si#ni8+antl) less than on a short-ter. *ond%
Optional Question
3uppose a 8r. will need C1"",""" 2" )ears fro. now to repla+e
so.e e>uip.ent% 7t plans to .a6e 2" e>ual pa).ents, startin# toda),
into an in'est.ent fund% 7t +an *u) *onds that .ature in 2" )ears or
*onds that .ature in 1 )ear% Both t)pes of *onds +urrentl) sell to
)ield 1"G, i%e%, r
d
R JT( R 1"G% The +o.pan)9s *est esti.ate of
future interest rates is that the) will sta) at +urrent le'els, i%e%, the)
.a) rise or the) .a) fall, *ut the e-pe+ted r
d
is the +urrent r
d
%
There is so.e +han+e that the e>uip.ent will wear out in less
than 2" )ears, in whi+h +ase the +o.pan) will need to +ash out its
in'est.ent *efore 2" )ears% 7f this o++urs, the +o.pan) will
desperatel) need the .one) that has *een a++u.ulatedIthis .one)
+ould sa'e the *usiness% Bow .u+h should the 8r. plan to in'est
ea+h )ear?
Answer 3tart with a ti.e line
" 1 2 11 12 2"
P P P P P P
4(T 4(T 4(T 4(T 4(T
QV
12
QV
11
%
%
%
QV
"
3u. of QVs R1"","""
;e ha'e a 2"-)ear annuit) due whose QV R 1"",""", where
r
d
R 1"G% ;e +ould set the +al+ulator to D*e#innin#E or
Ddue,E insert the 6nown 'alues (N R 2", r
d
R 75J& R 1", 4V R
", QV R 1"""""), and then press the 4(T *utton to 8nd the
pa).ent, 4(T R C1,/17%24% Thus, if we sa'e C1,/17%24 per
)ear, startin# toda), and in'est it to earn 1"G per )ear, we
would end up with the re>uired C1"","""% Note, thou#h,
that this +al+ulation assu.es that the +o.pan) +an earn
1"G in ea+h future )ear% 7f interest rates fall, it +ould not
earn 1"G on its additional depositsT hen+e, it would not end
up with the re>uired C1"","""%
Optional Question
7f the +o.pan) de+ides to in'est enou#h ri#ht now to produ+e the
future C1"",""", how .u+h is its outla)?
Answer To 8nd the re>uired initial lu.p su., we would 8nd the 4V
of C1"",""" dis+ounted *a+6 for 2" )ears at 1"G 4V R
C14,104%30% 7f the +o.pan) in'ested this a.ount now and
1"G
earned 1"G, it would end up with the re>uired C1"","""%
Note a#ain, thou#h, that if interest rates fall, the interest
re+ei'ed in ea+h )ear will ha'e to *e rein'ested to earn less
than 1"G, and the C1"",""" #oal will not *e .et%
Mi'en the fa+ts as we ha'e de'eloped the., if the
+o.pan) de+ides on the lu.p su. pa).ent, should it *u)
1-)ear *onds or 2"-)ear *onds? Neither will *e +o.pletel)
safe in the sense of assurin# the +o.pan) that the re>uired
C1"",""" will *e a'aila*le in 2" )ears, *ut is one *etter
than the other? To *e#in, let9s loo6 at this ti.e line
" 1 2 11 12 2"
P P P P P P
14,104%30 1"","""
1-)ear 10,3/1 ? ? Mreater
un+ertaint)
2"-)ear 1,410 1,410 ? $ess un+ertaint)
The +o.pan) will in'est C14,104 at t R "% Then, it would
ha'e C1,410%4" of interest to rein'est at t R 1 if it *ou#ht a
2"-)ear *ond, *ut it would ha'e C1,410 of interest plus
C14,104 of prin+ipal R C10,3/"%1" to rein'est at t R 1 if it
*ou#ht the 1-)ear *ond% Thus, *oth *onds are e-posed to
so.e rein'est.ent ris6, *ut the shorter-ter. *ond is .ore
e-posed *e+ause it would re>uire the rein'est.ent of .ore
.one)% Our +on+lusion is that the shorter the .aturit) of a
*ond, other thin#s held +onstant, the #reater its e-posure
to rein'est.ent ris6%
Optional Question
Can )ou thin6 of an) other t)pe of *ond that .i#ht *e useful for this
+o.pan)9s purposes?
1"G
Answer A <ero +oupon *ond is one that pa)s no interestIit has <ero
+oupons, and its issuer si.pl) pro.ises to pa) a stated
lu.p su. at so.e future date% F%C% 4enne) was the 8rst
.a=or +o.pan) to issue <eros, and it did so in 1211% There
was a de.and on the part of pension fund .ana#ers, and
in'est.ent *an6ers identi8ed this need%
;hen issuin# <eros, the +o.pan) (or #o'ern.ent unit)
si.pl) sets a .aturit) 'alue, sa) C1,""", and a .aturit)
date, sa) 2" )ears fro. now% There is so.e 'alue of r
d
for
*onds of this de#ree of ris6% Assu.e that our +o.pan)
+ould *u) 2"-)ear <eros to )ield 1"G% Thus, our +o.pan)
+ould *u) 1"" <eros with a total .aturit) 'alue of 1""
C1,""" R C1"","""% 7t would ha'e to pa) C14,104%30, the
4V of C1"",""" dis+ounted *a+6 2" )ears at 1"G% Bere is
the rele'ant ti.e line
" 1 2 12 2"
P P P P P
'alue
A++rued
R 14,104%3010,3/1 17,210 2",2"2 1"",""" R
QV
Assu.in# the <ero +oupon *ond +annot *e +alled for earl)
pa).ent, the +o.pan) would fa+e no rein'est.ent ris6I
there are no inter'enin# +ash Hows to rein'est, hen+e no
rein'est.ent ris6% Therefore, the +o.pan) +ould *e sure of
ha'in# the re>uired C1"",""" if it *ou#ht hi#h >ualit)
<eros%
Optional Question
;hat t)pe of *ond would )ou re+o..end that it a+tuall) *u)?
3" Interated Case Chapter 7 Bonds and Their Valuation
1"G
Answer 7t is te.ptin# to sa) that the *est in'est.ent for this
+o.pan) would *e the <eros, *e+ause the) ha'e no
rein'est.ent ris6% But suppose the +o.pan) needed to
li>uidate its *ond portfolio in less than 2" )earsT +ould that
aLe+t the de+ision? The answer is D)es%E 7f 1-)ear *onds
were pur+hased, an in+rease in interest rates would not
+ause .u+h of a drop in the 'alue of the *onds, *ut if
interest rates rose to 2"G the )ear after the pur+hase, the
'alue of the <eros would fall fro. the initial C14,104 to
4V R C1"","""(1%2")
-12
R C3,13"%"2%
;hen we redu+e rein'est.ent ris6, we in+rease pri+e ris6%
Also, sin+e inHation aLe+ts rein'est.ent rates and, often,
the future funds needed, this +ould ha'e a *earin# on the
de+ision% The proper de+ision re>uires a *alan+in# of all
these fa+tors% One +an >uantif) the out+o.es to a +ertain
e-tent, de.onstratin# what would happen under diLerent
+onditions, *ut, in the end, a de+ision in'ol'in# =ud#.ent
.ust *e .ade%
7% Bow does the e>uation for 'aluin# a *ond +han#e if
se.iannual pa).ents are .ade? Qind the 'alue of a 1"-
)ear, se.iannual pa).ent, 1"G +oupon *ond if no.inal rd R
13G%
Answer @3how 37-21 and 37-22 here%A 7n realit), 'irtuall) all *onds
issued in the K%3% ha'e se.iannual +oupons and are 'alued
usin# the setup shown *elow
1 2 N Jears
" 1 2 3 4 2N - 1 2N 3A
periods
P P P P P P P
7NT52 7NT52 7NT52 7NT52 7NT52 7NT52
4V
1
(
%
%
%
4V
N
4V
(
V
Bond
R 3u. of 4Vs
;e would use this e>uation to 8nd the *ond9s 'alue
V
B
R
=
+
N 2
1 t
t
d
52) r (1
7NT52

V
N 2
d
) 2 5 r 1 (
(
+
%
The pa).ent strea. +onsists of an annuit) of 2N pa).ents
plus a lu.p su. e>ual to the .aturit) 'alue%
To 8nd the 'alue of the 1"-)ear, se.iannual pa).ent
*ond, 3e.iannual interest R Annual +oupon52 R C1""52 R
C/" and N R 2 Jears to .aturit) R 2(1") R 2"% To 8nd the
'alue of the *ond with a 8nan+ial +al+ulator, enter N R 2",
r
d
52 R 75J& R /, 4(T R /", QV R 1""", and then press 4V to
deter.ine the 'alue of the *ond% 7ts 'alue is C1,"""%
Jou +ould then +han#e r
d
R 75J& to see what happens to
the *ond9s 'alue as r
d
+han#es, and plot the 'alues%
Qor e-a.ple, if r
d
rose to 13G, we would input 75J& R
0%/ rather than /, and 8nd the 1"-)ear *ond9s 'alue to *e
C134%72% 7f r
d
fell to 7G, then input 75J& R 3%/ and press 4V
to 8nd the *ond9s new 'alue, C1,213%12%
F% 3uppose for C1,""" )ou +ould *u) a 1"G, 1"-)ear, annual
pa).ent *ond or a 1"G, 1"-)ear, se.iannual pa).ent
*ond% The) are e>uall) ris6)% ;hi+h would )ou prefer? 7f
C1,""" is the proper pri+e for the se.iannual *ond, what is
the e>uili*riu. pri+e for the annual pa).ent *ond?
Answer @3how 37-3" and 37-31 here%A The se.iannual pa).ent
*ond would *e *etter% 7ts EA& would *e
EA& R G% 2/ % 1" 1
2
1" % "
1 1
(
r
1
2 (
NO(
=
+ =
+
An EA& of 1"%2/G is +learl) *etter than one of 1"%"G, whi+h
is what the annual pa).ent *ond oLers% Jou, and e'er)one
else, would prefer it%
7f the #oin# rate of interest on se.iannual *onds is r
NO(

R 1"G, with an EA& of 1"%2/G, then it would not *e
appropriate to 8nd the 'alue of the annual pa).ent *ond
usin# a 1"G EA&% 7f the annual pa).ent *ond were traded
in the .ar6et, its 'alue would *e found usin# 1"%2/G,
*e+ause in'estors would insist on re+ei'in# the sa.e EA&
on the two *onds, *e+ause their ris6 is the sa.e%
Therefore, )ou +ould 8nd the 'alue of the annual pa).ent
*ond, usin# 1"%2/G, with )our +al+ulator% 7t would *e
C214%1" 'ersus C1,""" for the se.iannual pa).ent *ond%
Note that, if the annual pa).ent *ond were sellin# for
C214%1" in the .ar6et, its EA& would *e 1"%2/G% This 'alue
+an *e found *) enterin# N R 1", 4V R -214%1", 4(T R 1"",
and QV R 1""" into a 8nan+ial +al+ulator and then pressin#
the 75J& *utton to 8nd the answer, 1"%2/G% ;ith this rate,
and the C214%1" pri+e, the annual and se.iannual pa).ent
*onds would *e in e>uili*riu.Iin'estors would re+ei'e the
sa.e rate of return on either *ond, so there would not *e a
tenden+) to sell one and *u) the other (as there would *e if
the) were *oth pri+ed at C1,"""%)
Z% 3uppose a 1"-)ear, 1"G, se.iannual +oupon *ond with a
par 'alue of C1,""" is +urrentl) sellin# for C1,13/%2",
produ+in# a no.inal )ield to .aturit) of 1G% Bowe'er, it
+an *e +alled after 4 )ears for C1,"/"%
(1) ;hat is the *ond9s no.inal )ield to +all (JTC)?
Answer @3how 37-32 and 37-33 here%A 7f the *ond were +alled,
*ondholders would re+ei'e C1,"/" at the end of Jear 4%
Thus, the ti.e line would loo6 li6e this
" 1 2 3 4
P P P P P P P P P
/" /" /" /" /" /" /" /"
1,"/"
4V
1
%
%
%
4V
3
4V
4+
4V
4+p
1,13/%2" R 3u. of 4Vs
The easiest wa) to 8nd the JTC on this *ond is to input
'alues into )our +al+ulator N R 1T 4V R -113/%2"T 4(T R
/"T and QV R 1"/", whi+h is the par 'alue plus a +all
pre.iu. of C/"T and then press the 75J& *utton to 8nd 75J&
R 3%/01G% Bowe'er, this is the 0-.onth rate, so we would
8nd the no.inal rate on the *ond as follows
r
NO(
R 2(3%/01G) R 7%137G 7%1G%
This 7%1G is the rate *ro6ers would >uote if )ou as6ed
a*out *u)in# the *ond%
Jou +ould also +al+ulate the EA& on the *ond
EA& R (1%"3/01)
2
[ 1 R 7%20G%
Ksuall), people in the *ond *usiness =ust tal6 a*out no.inal
rates, whi+h is OZ so lon# as all the *onds *ein# +o.pared
are on a se.iannual pa).ent *asis% ;hen )ou start
.a6in# +o.parisons a.on# in'est.ents with diLerent
pa).ent patterns, thou#h, it is i.portant to +on'ert to
EA&s%
Z% (2) 7f )ou *ou#ht this *ond, would )ou *e .ore li6el) to earn
the JT( or the JTC? ;h)?
Answer @3how 37-34 and 37-3/ here%A 3in+e the +oupon rate is 1"G
'ersus JTC R r
d
R 7%137G, it would pa) the +o.pan) to +all
the *ond, to #et rid of the o*li#ation of pa)in# C1"" per
)ear in interest, and to sell repla+e.ent *onds whose
interest would *e onl) C71%37 per )ear% Therefore, if
interest rates re.ain at the +urrent le'el until the +all date,
the *ond will surel) *e +alled, so in'estors should e-pe+t to
earn 7%137G% 7n #eneral, in'estors should e-pe+t to earn
the JTC on pre.iu. *onds, *ut to earn the JT( on par and
dis+ount *onds% (Bond *ro6ers pu*lish lists of the *onds
the) ha'e for saleT the) >uote JT( or JTC dependin# on
whether the *ond sells at a pre.iu. or a dis+ount%)
$% :oes the )ield to .aturit) represent the pro.ised or
e-pe+ted return on the *ond? E-plain%
Answer @3how 37-30 here%A The )ield to .aturit) is the rate of
return earned on a *ond if it is held to .aturit)% 7t +an *e
'iewed as the *ond9s pro.ised rate of return, whi+h is the
return that in'estors will re+ei'e if all the pro.ised
pa).ents are .ade% The )ield to .aturit) e>uals the
e-pe+ted rate of return onl) if (1) the pro*a*ilit) of default
is <ero and (2) the *ond +annot *e +alled% Qor *onds where
there is so.e default ris6, or where the *ond .a) *e +alled,
there is so.e pro*a*ilit) that the pro.ised pa).ents to
.aturit) will not *e re+ei'ed, in whi+h +ase, the pro.ised
)ield to .aturit) will diLer fro. the e-pe+ted return%
(% These *onds were rated AA- *) 3\4% ;ould )ou +onsider
the. in'est.ent-#rade or =un6 *onds?
Answer @3how 37-37 and 37-31 here%A These *onds would *e
in'est.ent-#rade *onds% Triple-A, dou*le-A, sin#le-A, and
triple-B *onds are +onsidered in'est.ent #rade% :ou*le-B
and lower-rated *onds are +onsidered spe+ulati'e, or =un6
*onds, *e+ause the) ha'e a si#ni8+ant pro*a*ilit) of #oin#
into default% (an) 8nan+ial institutions are prohi*ited fro.
*u)in# =un6 *onds%
N% ;hat fa+tors deter.ine a +o.pan)9s *ond ratin#?
Answer @3how 37-32 and 37-4" here%A Bond ratin#s are *ased on
*oth >ualitati'e and >uantitati'e fa+tors, so.e of whi+h are
listed *elow%
1% Qinan+ial perfor.an+eIdeter.ined *) ratios su+h as
the de*t, T7E, and +urrent ratios%
2% Qualitati'e fa+torsIBond +ontra+t ter.s
a% 3e+ured 's% unse+ured de*t
*% 3enior 's% su*ordinated de*t
+% Muarantee pro'isions
d% 3in6in# fund pro'isions
e% :e*t .aturit)
3% (is+ellaneous >ualitati'e fa+tors
a% Earnin#s sta*ilit)
*% &e#ulator) en'iron.ent
+% 4otential produ+t lia*ilit)
d% 4otential antitrust issues
e% 4ension lia*ilities
f% 4otential la*or pro*le.
O% 7f this 8r. were to default on the *onds, would the
+o.pan) *e i..ediatel) li>uidated? ;ould the
*ondholders *e assured of re+ei'in# all of their pro.ised
pa).ents? E-plain%
Answer @3how 37-41 throu#h 37-44 here%A ;hen a *usiness
*e+o.es insol'ent, it does not ha'e enou#h +ash to .eet
s+heduled interest and prin+ipal pa).ents% A de+ision .ust
then *e .ade whether to dissol'e the 8r. throu#h
li>uidation or to per.it it to reor#ani<e and thus sta) ali'e%
The de+ision to for+e a 8r. to li>uidate or to per.it it
to reor#ani<e depends on whether the 'alue of the
reor#ani<ed 8r. is li6el) to *e #reater than the 'alue of the
8r.9s assets if the) were sold oL pie+e.eal% 7n a
reor#ani<ation, a +o..ittee of unse+ured +reditors is
appointed *) the +ourt to ne#otiate with .ana#e.ent on
the ter.s of a potential reor#ani<ation% The reor#ani<ation
plan .a) +all for a restru+turin# of the 8r.9s de*t, in whi+h
+ase the interest rate .a) *e redu+ed, the ter. to .aturit)
len#thened, or so.e of the de*t .a) *e e-+han#ed for
e>uit)% The point of the restru+turin# is to redu+e the
8nan+ial +har#es to a le'el that the 8r.9s +ash Hows +an
support%
7f the 8r. is dee.ed to *e too far #one to *e sa'ed, it
will *e li>uidated and the priorit) of +lai.s (as seen in ;e*
Appendi- 7C) would *e as follows
1% 3e+ured +reditors%
2% Trustee9s +osts%
3% E-penses in+urred after *an6rupt+) was 8led%
4% ;a#es due wor6ers, up to a li.it of C2,""" per wor6er%
/% Clai.s for unpaid +ontri*utions to e.plo)ee *ene8t
plans%
0% Knse+ured +lai.s for +usto.er deposits up to C2"" per
+usto.er%
7% Qederal, state, and lo+al ta-es%
1% Knfunded pension plan lia*ilities%
2% Meneral unse+ured +reditors%
1"% 4referred sto+6holders, up to the par 'alue of their
sto+6%
11% Co..on sto+6holders, if an)thin# is left%
7f the 8r.9s assets are worth .ore Dali'eE than Ddead,E
the +o.pan) would *e reor#ani<ed% 7ts *ondholders,
howe'er, would e-pe+t to ta6e a Dhit%E Thus, the) would
not e-pe+t to re+ei'e all their pro.ised pa).ents% 7f the
8r. is dee.ed to *e too far #one to *e sa'ed, it would *e
li>uidated%

Chapter 7 (13E) Bonds and Their Valuation: Answers To End-of-Chapter Questions

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 7 (13E) Bonds and Their Valuation: Answers To End-of-Chapter Questions

Uploaded by

Copyright:

Available Formats

Chapter 7(13E)

Bonds and Their Valuation

Chapter 7 Bonds and Their Valuation Interated Case 2/

You might also like