Solutions to Concept Questions 8

Prof. Jeffrey Wurgler

1. A bond with face value $100 that is issued at a price of $105:
(a) is a discount bond
(b) is a par bond
(c) is a premium bond
(d) does not exist because nobody would want to buy an asset for 105 that ultimately
only pays 100.
Answer: The correct answer is (c).
This is the definition of a premium bond. It is a bond whose price is
greater than its face value.
2. The inflation rate for the coming year is 2%. A treasury Inflation Protected
bond (TIPS) with one year maturity, 1 coupon of $5 and face value of $100
will pay how much at maturity:
(a) 105
(b) 105*1.02
(c) 105/1.02
(d) 5+100*1.02
Answer: The correct answer is (b).
The difference between TIPS and a regular bond is that the TiPS have
an adjustment factor that scales up the payments of the bond to compensate the investor for inflation. The adjustment factor is equal to the
accumulated rate of inflation over the life of the bond. Hence, for this
bond it is equal to 1.02 (since inflation is 2% for one year). As the face
value paid by the bond is $100 and the coupon is $5, the answer is just
(b).
3. If your company has issued callable bonds in the past, when would be a
good time to call them?
(a) When companys profits are up.
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(b) When the company decided not to issue a dividend to the shareholders
(c) When the interest rate are now higher than they were when the bonds were first
issued
(d) When the interest rate are now lower than they were when the bonds were first
issued
Answer: The correct answer is (d).
A callable bond gives the company the right to buy the bond back from
its owners by paying them just the face value of the bond. This will be
beneficial to the company if the bond price is more than the face value
(it is currently a premium bond). This will happen when interest rates
decrease because the fall in interest rates will increase the price of the
bond. It is then in the companys interest to issue a new bond under
the lower interest rate environment, and use the proceeds to call back
the previous bond at its face value. Thet net effect will be to save the
company money in interest payments.
4. What is the yield to maturity on a 5 year zero coupon paying bond with
face value 100 and price equal to 85?
(a) 100/85 1
(b) 85/100 1
(c) (100/85)5 1
(d) (100/85)0.2 1
Answer: The correct answer is (d).
This comes from the formula for and definition of yield to maturity. If
the face value is $100 and the price is P, the yield to maturity is given
by (100/P )(1/T ) 1. Substituting in gives answer (d).
5. How do you compute the EAR on a semi-annual coupon paying bond (rather
than as a semiannual APR or as a periodic 6-month rate)?
(a) You assume that the bond is twice as long as its actual maturity and you compute
the IRR. The EAR is 2 IRR.
(b) You assume that the bond is twice as long as its actual maturity and you compute
the IRR. The EAR is (1 + IRR)2 1.
(c) You assume that the bond is half as long as its actual maturity and you compute
the IRR. The EAR is (1 + IRR 2)2 1.
(d) You compute the YTM directly but discount the first cash-flow by 6 months, the
second one by 1 year, the third one by 18 months, etc... EAR = YTM

Answer: The correct answer is (b).

The return per period is given by the IRR per period. The EAR properly
annualizes this per period return, i.e. it tells you what is the annual rate
of return if you compound the per period rate. Since the bond is semiannual paying, coupons are paid every six months. Thus each period is
six months. Hence, the computed IRR is per six months and to annualize
the rate we do: (1 + IRR)2 1 since, of course, there are two six month
periods in each year.
6. If the YTM on a 2 year zero coupon bond that starts today is 5% and the
YTM on a 1 year zero coupon bond that starts today is 3%. What does the
no-arbitrage condition tell you about the interest rate on a one year bond
that starts next year?
(a) Its the average of 3% and 5%
(b) Its 5% 3%
(c) Its ((1.05)2/1.03) 1
(d) Its (1.05/1.03) 1
Answer: The correct answer is (c).
To figure this out, we need to equate the returns one earn on two alternative, but equivalent, investments: (1) Invest in a two-year zero coupon
bond or (2) Invest in the 1 year bond and the one year bond that starts
in one year. Investment (2) will return 3% over the first year and f
over the second year (the yield on the one year bond that starts in one
year). Investment (1) returns 5% per year. Hence, we are equating
1.052 = 1.03 (1 + f ). Solving for f gives f = 1.052 /1.03 1.
7. If the YTM on a 20 year T-bond is lower than the YTM on a 3 month
T-bill, then, according to the expectations hypothesis theory,
(a) Investors expect future short rates to be higher than the current 3 month interest
rate.
(b) Investors expect future short rates to be equal to the current 3 month interest
rate.
(c) Investors expect future short rates to be lower than the current 3 month interest
rate.
(d) None of the above.

Answer: The correct answer is (c).

According to the expectations hypothesis, forward rates are equal to
investors expectations of future short interest rates. Since the 20 year
YTM is lower than the 3 month interest rate, the forward rates must
be lower than the 3 month interest rates. According to the expectations
hypothesis, that forward rates are below the current 3 month interest
rate means that investors expect future short rates to be lower than the
current 3 month interest rate.
8. What is true about the predictions of the expectations hypothesis (EH) and
liquidity premium (LP) theories of the yield curve about the average slope
of the yield curve?
(a) In EH, the average yield curve is upward sloping and in LP it is flat.
(b) In EH, the average yield curve is downward sloping and in LP it is flat.
(c) In EH, the average yield curve is flat and in LP it is downward sloping.
(d) In EH, the average yield curve is flat and in LP it is upward sloping.
Answer: The correct answer is (d).
In EH, forward rates are equal to expected short rates so the average
forward rate is equal to the average short rate. Hence, the average for
all forward rates is the same. It is just equal to the average short rate.
Hence, the average slope of the yield curve is flat (sometimes the yield
curve is upward sloping, sometimes downward sloping, but taking the
average across all times gives a flat yield curve). On the other hand,
the LP says that as compensation for holding long-term bonds, investors
demand a liquidity premium. This means yields are higher for longer
maturity bonds and the yield curve tends to be upward sloping. Equivalently, forward rates are higher than expected short rates and on average
the yield curve is upward sloping.
9. If the current one year zero coupon bond yield is 4% and the current two
year zero coupon bond yield is 3%, then what do investors expect about the
one year zero coupon bond yield next year if the expectations hypothesis
is true?
(a) They expect next years one year yield to be roughly 2%.
(b) They expect next years one year yield to be roughly 5%.
(c) They expect next years one year yield to be roughly 3.5%.
(d) They expect next years one year yield to be roughly 1%.

Answer: The correct answer is (a).

By the EH, the forward rate is investors expectation for next years
one-year interest rate, which is just next years zero coupon bond yield.
This forward rate is the rate one needs to earn next year to get the
same return from holding two one-year zero coupon bonds in succession
as from holding the two-year zero coupon bond. Hence, f is given by:
(1 + 0.04)(1 + f ) = (1.03)2. Solving for f gives that is f is approximately
2%.
10. According to the liquidity premium theory, the forward rate is
(a) a good predictor of future expected short rates.
(b) a downward biased predictor of future expected short rates.
(c) an upward biased predictor of future expected short rates.
(d) uninformative about future expected short rates.
Answer: The correct answer is (c).
The liquidity premium theory says that investors require extra compensation for risk for holding longer maturity bonds. Hence, forward rates
incorporate a risk compensation. That is, forward rates are set by investors to be higher than their actual expectation of future short rates
as compensation for risk. Thus, there is an upward bias in forward rates
relative to future expected short rates.
11. Suppose you buy a 2-year 4% coupon paying bond, with face value equal
to $1000, and a YTM of 4%. The price of that coupon paying bond is
(a) 1000
(b) 1000/1.04
(c) 1040/1.042
(d) 1080/1.042
Answer: The correct answer is (a).
As discussed earlier in the class, when the YTM on a coupon-paying
bond is equal to the coupon rate, the bond price will be equal to the
face value (it will be a par bond). One can also verify this by calculating
the price directly. It will be given by 40/1.04 + 1040/1.042, which equals
1000.
12. Suppose you buy a 2-year 4% coupon paying bond, with face value equal
to $1000, and a YTM of 4%. You hold the bond until maturity. From year
1 to year 2, you reinvest the coupon at 8% interest rate. The annualized
holding period return on that investment is
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(a) Equal to the YTM of 4%

(b) Greater than the YTM of 4%
(c) Smaller than the YTM of 4%
(d) There is not enough information to answer this question
Answer: The correct answer is (b).
In class we discussed how, if the reinvestment rate of return is equal to the
YTM, then the YTM and annualized holding period return will be equal.
If the reinvestment rate of return is higher than the YTM, as is the case
here, then the annualized holding period return will be greater than the
YTM. This is because we were able to revinest funds at a rate of return
that is even higher than the YTM, which raises the overall holding period
return. Recall that the annualized holding period return is the return
that one needs to earn to transform the initial investment into the total
forward value of all the payouts from the investment. Here the initial
investment is $1000 (as calculated in the previous question). The forward
value of all payouts (forwarded to year 2) is: 40 1.08 + 1040. Hence,
the annualized holding period return is given by: 1000 (1 + ann.ret)2 =
40 1.08 + 1040. Solving this shows that ann.ret = 4.077%, which is
greater than 4%.