Professional Documents
Culture Documents
Chapter11
BondValuation
.1
Outline
Learning Goals
I.
TheBehaviorofMarketInterestRates
A) KeepingTabsonMarketInterestRates
B) WhatCausesInterestRatestoMove?
C) TheTermStructureofInterestRatesandYieldCurves
1. TypesofYieldCurves
2. PlottingYourOwnCurves
3. ExplanationsoftheTermStructureofInterestRates
a. ExpectationsHypothesis
b. LiquidityPreferenceTheory
c. MarketSegmentationTheory
d. Whichtheoryisright?
4. UsingtheYieldCurveinInvestmentDecisions
ConceptsinReview
II.
ThePricingofBonds
A) AnnualCompounding
B) SemiannualCompounding
ConceptsinReview
III. MeasuresofYieldandReturn
A) CurrentYield
B) YieldtoMaturity
197Gitman/JoehnkFundamentalsofInvesting,NinthEdition
1. UsingSemiAnnualCompounding
2. YieldProperties
3. FindingtheYieldonaZero
C) YieldtoCall
D) ExpectedReturn
E) ValuingaBond
ConceptsinReview
Chapter11BondValuation198
IV. DurationandImmunization
A) TheConceptofDuration
B) MeasuringDuration
1. DurationforaSingleBond
2. DurationforaPortfolioofBonds
C) BondDurationandPriceVolatility
D) UsesofBondDurationMeasures
1. BondImmunization
ConceptsinReview
V.
BondInvestmentStrategies
A) PassiveStrategies
B) TradingonForecastedInterestRateBehavior
C) BondSwaps
ConceptsinReview
Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
11.1. TheBondInvestmentDecisionsofKelleyandErinCoates
11.2. GraceDecidestoImmunizeHerPortfolio
ExcelwithSpreadsheets
.2
Key Concepts
1.
Theimportantrolethatinterestratesplayinthebondinvestmentprocessandthebasicdeterminants
ofmarketrates.
2.
Thetermstructureofinterestratesandyieldcurves.
3.
Fundamentalsofbondvaluation,includingbasicmeasuresofyieldandreturn.
4.
Theconceptofdurationanditsmeasurement;howdurationisappliedinimmunizingbondportfolios.
5.
Varioustypesofbondinvestmentprogramsandthewaysdebtsecuritiescanbeusedbyinvestors.
Employmentofbondladdersisapassivestrategy,whereasbuyinghighdurationbondspriorto
interestratedropswouldbeamoreactiveandriskystrategy.
199Gitman/JoehnkFundamentalsofInvesting,NinthEdition
.3
Overview
Chapter11BondValuation200
1.
Interestratesareanintegralcomponentofthebondvaluationprocess.Someclasstimeshouldbe
spentdiscussingtheeconomicsofinterestrates.Thevariousforcesthatdriveinterestratesshouldbe
coverednext.Inthiscontext,theinstructorcanintroducethetermstructureofinterestrates.
2.
Thetextthenpresentsthreedifferentexplanationsofthetermstructureofinterestrates:the
ExpectationsHypothesis,theLiquidityPreferenceTheory,andtheMarketSegmentationTheory.The
discussionofthisimportanttopicshouldincludeyieldcurves,howtheyareplotted,andtheirusein
makinginvestmentdecisions.
3.
Thenextsectiondiscussesthebondvaluationprocess.Itshowshow,giventhemarketrateofinterest
andotherdetailsregardingthebond(suchasthematurity,coupon,andfacevalue),itispossibleto
computethecorrectpriceofthebond.Anexampleshowingthiscomputationshouldbeworkedout
inclass,includinghowfluctuationsinthemarketinterestratesinducechangesinthepriceofthe
bond.Themagnitudeofpricechangesdependsontheamountofchangeinthemarketinterestrate,as
wellasonthematurityandcouponofthebond.
4.
Theconceptsofbondyieldsandreturns,alongwiththecomputationanduseofcurrentyield,
promisedyield,yieldtocall,andexpectedyield,arediscussednext.Theinstructormaywishto
demonstratethetrialanderrorprocedure,tocalculatetheyieldtomaturityusingtables.Itisalso
importanttoemphasizethatwhatmatterstoinvestorsisthereturnfromthebond,notitsyield.
5.
Bonddurationisoneofthemostimportantconceptsinbondvaluationandinvesting.After
demonstratingtheshortcomingsofyieldtomaturity,theconceptandmeasurementofdurationcan
beillustrated.Inthisregard,theinstructorcanworkoutanexampletoillustratehowdurationand
modifieddurationaidinvestorsingaugingabondspricevolatility.
6.
Bondimmunizationispresentednext.Thistechniquepreservesthevalueofabondportfolio.Bond
immunizationinvolvesconstructingabondportfoliowithaweightedaveragedurationthatmatches
theinvestorsinvestmenthorizon.
7.
Bondinvestmentstrategiescanbeeitheractiveorpassive.Passiveinvestmentstrategiesincludebuy
andholdandbondladders.Tradingoninterestrateswingsandbondswapsareconsideredactive
strategies.Theinstructormightpointouttheadvantagesanddisadvantages(risks)ofeachtechnique.
8.
Oneinterestingteachingstrategyistostartoutwithabondpricedatparandshowthedecine/rise
fromaninterestratedecrease/increaseofthesamemagnitude.Duetoconvexity,bondpriceswillrise
fasterthantheydecline!
.4
1.
201Gitman/JoehnkFundamentalsofInvesting,NinthEdition
2.
Thebehaviorofinterestratesisperhapsthesinglemostimportantelementindeterminingthelevelof
returnfromabondinvestmentprogram.Interestratesaffectthelevelofcurrentincomeearnedby
conservativeinvestors,aswellastheamountofcapitalgainsgeneratedbyaggressivebondtraders.
Whereasconservativeinvestorsareprimarilyconcernedwiththelevelofinterestrates,aggressive
investorsareinterestedchieflyinmovementsininterestrates(theamountofinterestratevolatility).
Someofthemajordeterminantsofinterestratesinclude:inflation,themoneysupply,thedemandfor
loanablefunds,theamountofdeficitspendingbytheFederalGovernment,andactionsoftheFederal
Reserve(likechangesinthediscountrate).Individualinvestorscanmonitorinterestratesand
formulateinterestrateexpectationsonaninformalbasisthroughtheuseofreportsobtainedfrom
theirbrokers,frominvestorservices(e.g.,S&PsCreditweek),and/orbyfollowingcolumns/articles
insuchbusinessandfinancialpublicationsasTheWallStreetJournalorBusinessWeek.
3.
Thetermstructureofinterestratesistherelationshipbetweentheinterestrateoryieldandthetimeto
maturityforanyclassofsimilarrisksecurities.Theyieldcurveisjustagraphicrepresentationofthe
termstructureofinterestratesatagivenpointintime.Toplotayieldcurve,youneedtoknowtheyield
tomaturityfordifferentmaturitiesofsimilarriskbonds.Asmarketconditionschange,theyieldcurves
shapeandlocationalsochange.
Theupwardslopingyieldcurveindicatesthatyieldstendtoincreasewithlongermaturities.The
longerabondhastogotomaturity,thegreaterthepotentialforpricevolatilityandtheriskofloss.
Thus,investorsrequirehigheryieldsonlongermaturitybonds.Flatyieldcurvesindicatethatyields
willbethesameacrossmaturities.Giventhatlongertermbondshavemoredefaultandmaturityrate
risk,aflatyieldcurveimpliesthatinflationratesareexpectedtodecline.
4.
Analyzingthechangesinyieldcurvesovertimeprovidesinvestorswithinformationaboutfuture
interestratemovementsandhowtheycanaffectpricebehaviorandcomparativereturns.For
example,ifoveraspecifictimeperiod,theyieldcurvebeginstorisesharply,itusuallymeansthat
inflationisincreasing.Investorscanexpectthatinterestrates,too,willrise.Undertheseconditions,
mostseasonedbondinvestorswouldturntoshortorintermediate(threetofiveyearmaturities).A
downwardslopingyieldcurvewouldsignalthatrateshavepeakedandareabouttofall.
Differencesinyieldsondifferentmaturitiesataparticularpointintime,orthesteepnessofthe
curve,isanindicationthatlongtermratesarelikelytofallsomewhattonarrowthespread,providing
anincentivetoinvestinlongertermsecurities.Steepyieldcurvesaregenerallyviewedasasignsthat
longtermratesareneartheirpeak.
Evenamonglongertermmaturities,thespreadbetweendifferentlongertermmaturitiesshouldbe
consideredbeforemakingadecisiontoinvest.Forexample,ifthespreadbetween10and30year
maturitiesisnotlargeenough(say,lessthan20basispoints),thentheinvestorshouldfavorthe
10yearbond,becausehewouldnotgainenoughtocompensateforinvestinginthemuchriskier
30yearmaturity.Inanycase,theinvestorwouldhavetoconsiderhisorherownrisktoleranceto
determinewhethertheriskpremiumwassufficientfortheadditionalriskofbuyinglongerterm
securities.
Bondpricesaredrivenbymarketyields.Inthemarketplace,theappropriateyieldatwhichthebond
shouldsellisdeterminedfirst,andthenthatyieldisusedtofindthepriceofthebond.Theyieldisa
functionofcertainmarketandeconomicforces,suchastheriskfreerateandinflation,aswellaskey
issueandissuercharacteristics,suchasthematurityoftheissueandagencyratingassignedtothe
bond.
Youcannotvalueabondwithoutknowingitsmarketyield,whichfunctionsasthediscountrateinthe
bondvaluationprocess.
5.
Chapter11BondValuation202
6.
Bondsareusuallypricedusingsemiannualcompoundingbecauseinpractice,mostbondspayinterest
everysixmonths.Semiannualcompoundingmakesdiscountingofsemiannualcouponpayments
moreprecise,resultinginmoreaccuratevaluation.However,usingannualcompoundingsimplifies
thevaluationprocessabitanddoesnotmakeverymuchdifferenceinvalue.Withhighercoupons
andlongermaturities,thedifferenceincreasesmore.Bondsofferingsemiannualpaymentswillbe
pricedhigher.
7.
Currentyieldisameasureofabondscurrentincome.Itistheamountofcurrentincomeabond
providesrelativetoitsprevailingmarketprice.Yieldtomaturityisamorecompletemeasureand
evaluatesbothinterestincomeandpriceappreciation.Yieldtomaturityindicatesthefully
compoundedrateofreturnearnedbyaninvestor,giventhatthebondisheldtomaturityandall
principalandinterestpaymentsaremadeinapromptandtimelyfashion.
Promisedyieldisthesameasyieldtomaturity.Promisedyieldiscomputedassumingthebondis
heldtomaturityandthecouponcashflowsarereinvestedatthebondscomputedpromisedyield.
Realizedyieldistherateofreturnaninvestorcanexpecttoearnbyholdingabondoveraperiodof
timethatislessthanthelifeoftheissue.Realizedyieldisusedbybondtraderswhotradeinandout
ofbondsovershortholdingperiods.
8.
Whenwearedealingwithsemiannualcashflows,tobetechnicallycorrect,weshouldfindthe
bondseffectiveannualyield.Butthemarketconventionforfindingtheannualyieldistodouble
thesemiannualyield.Thispracticeproduceswhatthemarketreferstoasthebondequivalentyield.
Thus,givenasemiannualyieldof4%,accordingtothebondequivalentyieldconvention,theannual
rateofreturnofthisbondifheldtomaturityis8%.Thisisalsothesameasthebondspromised
yieldoryieldtomaturity.
9.
Thereinvestmentofinterestincomeisanimportantconsideration,becauseitisthisratethatan
investormustearnoneachoftheinterimcashthrowoffsinordertorealizeareturnequaltoor
greaterthanthepromisedyieldonabond.Ascashisreceivedfrominterestincome,theequationfor
promisedyieldimplicitlyassumesthiscashpaymentwillbereinvestedatarateofreturnequaltothe
issuespromisedyield;failuretodosomeanstheinvestorwillgeneratearealizedyieldthatisless
thanpromised.
10. Durationisameasureofbondpricevolatility.Itcapturesbothpriceandreinvestmentrisksina
singlemeasureandindicateshowabondspricewillreacttodifferentinterestrateenvironments.Itis
theeffectivematurityofafixedincomesecurity.Ontheotherhand,thebondsactualmaturitydoes
notconsiderallofthebondscashflowsnordoesitconsiderthetimevalueofmoney.Durationisa
farsuperiormeasureoftheeffectivetimingofabondscashflows,becauseitexplicitlyconsiders
boththetimevalueofmoneyandthebondscouponandprincipalpayments.
Whenthemarketundergoesabigchangeinyield,durationwillunderstatepriceappreciationwhen
ratesfallandoverstatethepricedeclinewhenratesincrease.Modifieddurationisusedtoovercome
thisproblembylinkinginterestratechangestochangesinbondprice.First,youcancomputethe
modifieddurationusingthebondscomputeddurationandthecomputedyieldtomaturity.Then,the
changeinbondpricebaseduponachangeininterestratescanbecomputedasfollows:
Percentchangeinbondprice1ModifieddurationChangeininterestrates
203Gitman/JoehnkFundamentalsofInvesting,NinthEdition
11. Marketinterestratechangeshavetwoeffects:thepriceeffectandthereinvestmenteffect,which
occurinoppositedirections.Whenabondportfolioisimmunized,thesetwoeffectsexactlyoffset
eachotherandleavethevalueoftheportfoliounchanged.Thishappenswhentheweightedaverage
durationofthebondportfolioisexactlyequaltothedesiredinvestmenthorizon.Ifaportfoliois
constructedandcontinuouslyrebalancedsuchthattheweightedaveragedurationisequaltothe
desiredinvestmenthorizonatanyparticularpointintime,thentheportfolioissaidtobeimmunized
fromtheeffectsofinterestratechanges.
Bondimmunizationallowsaninvestortoderiveaspecifiedrateofreturnfrombondinvestments
regardlessofwhathappenstomarketinterestratesoverthecourseoftheholdingperiod.Thatis,the
investorsbondportfolioisimmunizedfromtheeffectsofchangesinmarketinterestratesovera
giveninvestmenthorizon.
Portfolioimmunizationisnotapassiveinvestmentstrategy;itrequirescontinualportfolio
rebalancingonthepartoftheinvestorinordertomaintainafullyimmunizedportfolio.The
compositionoftheportfolioshouldchangeeverytimeinterestrateschange,andalsowiththepassage
oftime.
12. Bondladdersareapassiveinvestmentstrategywherebyanequalamountofmoneyisinvestedina
seriesofbondswithstaggeredmaturities.Supposeaninvestorwantstoconfineherinvestingtofixed
incomesecuritieswithmaturitiesof10yearsorless.Shecouldsetuptheladderbyinvestingin
roughlyequalamountsof3,5,7,and10yearissues.Whenthe3yearissuematures,theproceeds
wouldbereinvestedinanew10yearnote.Similarrolloverswouldoccurwheneverabondmatures.
Eventually,theinvestorwouldholdafullladderofstaggered10yearnotes.Rollingintonew10year
issueseverytwoorthreeyearsallowstheinvestortodoakindofdollarcostaveragingandthereby
lessentheimpactofswingsinmarketrates.
Taxswapsinvolvereplacementofabondwithacapitallosswithasimilarsecurity.Bysellingthe
bondwiththecapitalloss,aninvestorcanoffsetacapitalgaingeneratedinanotherpartofthe
portfolioandtherebyreducetheoveralltaxliability.Identicalissuescannotbeusedforthiskindof
swap;theIRSwillrulesuchswapsaswashsalesandthereforedisallowthecapitalloss.
13. Anaggressivebondinvestorwouldemploythehighlyriskyforecastedinterestratebehaviorstrategy.
Theintentofthisstrategyistotakeadvantageofinterestrateswingsbytimingthemarket.Usually
theseswingsareshortlived,soaggressivebondtraderswilltrytomagnifytheirreturnsbytradingon
margin.Theseinvestorstrytogeneratecapitalgainswheninterestratesareexpectedtodeclineandto
preservecapitalwhenanincreaseininterestratesisexpected.
14. Theinterestsensitivityofabonddetermineshowmuchthebondspricewillfluctuateforagiven
changeininterestrates.Obviously,whenratesdrop,bondtraderswanttocapitalizeonthisandas
such,requireissuesthatwillrespondtotheseinterestratechanges.Bondswithlongermaturities
and/orlowercouponsrespondmorevigorouslytochangesinmarketrates;therefore,theyundergo
greaterpriceswings.Highgradeissuesarewidelyusedbyactivebondtraderssincetheseissuesare
generallymoreinterestsensitivethanlowerratedbondsforexample,marketbehaviorissuchthata
tripleAcorporatewillgenerallybefarmoreresponsivetointerestratesthanatripleBissue.A
deterioratingeconomywillresultinadeclineinthedemandformoneyandhenceinterestrates,butit
mightcausemoredefaultrisktotheholderofthetripleBbondissue.
Chapter11BondValuation204
.5
.6
1.
205Gitman/JoehnkFundamentalsofInvesting,NinthEdition
Liquiditypreferencetheory:Longtermbondratesshouldbehigherthanshortertermduetothe
conditiontherearemoreliquidmarketratesintheshortterm.Uncertaintyincreasesovertime
causingthedemandforahigherriskpremium(bondinterestrate).Thistheoryexpectsupward
slopingyieldcurves.Downwardslopingcurveswouldnotoccurinthistheorysinceitwould
contradictthebasicnotionthatuncertaintyincreaseswithtimeandtheriskpremiumadjusts
accordingly.
MarketSegmentationtheory:Thedebtmarketissegmentedaccordingtolengthofmaturityand
preferences.Anequilibriumexistsintheshorttermbetweensuppliersanddemandersoffunds.There
aredifferentinhabitantsineachsegmentwithdifferentmotivations.Intheshortterm,banks
predominate,butinthelongterm,lifeinsuranceandrealestatefirmsdeterminetheequilibriums.In
thistheoryyieldcurvesmaybeeitherupwardordownwardsloping,asdeterminedbythegeneral
relationshipbetweenratesineachmarketsegment.
2.
Answerswillvarywitheachstudentandtheconditionsprevailinginthemarketsatthetimethe
assignmentismade.
3.
(a)
(b)
(c)
(d)
4.
(a) Anaggressiveinvestorwouldbemoreconcernedwithcapitalgains,thatis,priceappreciation.
Inthisprocess,wewouldadvisehertoinvestinnewcompaniesthatmaybefoundontheOTC
markets.Thesecompanieshavehigherriskbuthigherreturns.Wemightalsosuggestamore
speculativestrategysuchasmarginbuyingorshortsellingdependentonthecurrentconditionsin
themarkets.
(b) Averyconservativeinvestormightincludeonlyinvestmentgradecorporate,government,and
municipalbondsinherportfolio.Thiswouldproduceaminimumofmarketlossesandrisk.
(c) (1) aninsurancecompanythatmustrelyonpredictableincomestreams
(2) aninvestorwhowantstomaximizeyield
(3) anindividualorinstitutionthatisnotasconservative
(4) aninvestorwhohasabuyandholdinvestmentstrategyandaspecificdateatwhichthe
fundswillbeneeded
5.
Answerswillvarywitheachstudent.
.7
1.
Higheryieldsleadtoshorterdurations,loweryieldsleadtolongerdurations.
Longermaturitiesmeanlongerdurations,shortermaturitiesmeanshorterdurations.
Highercouponsresultinshorterdurations,lowercouponsresultinlongerdurations.
Yieldtomaturityhasincreased.
Solutions to Problems
BondA:$1,000parvalue,5%coupon,15yearlife,pricedtoyield8%
BondB:$1,000parvalue,7.5%coupon,20yearlife,pricedtoyield6%
BondA,witha5%couponandan8%yield,mustsellatadiscount;itwillbepricedbelow$1,000.
BondB,ontheotherhand,isapremiumbond(itscouponisgreaterthanitsyield)anditwillsellata
muchhigherpricethanBondA:
PriceofBondA $50PVIFA8%,15yrs.$1,000PVIF8%,15yrs.
$508.560$1,0000.315
$428315$743
PriceofBondB $75PVIFA6%,20yrs.$1,000PVIF6%,20yrs.
Chapter11BondValuation206
$7511.470$1,0000.312
$860.25312$1,172.25
207Gitman/JoehnkFundamentalsofInvesting,NinthEdition
2.
Bondpricesusingsemiannualcompounding:
(a) 10%,15years,YTMof8%
Price $52.50PVIFA4%,30yrs.$1,000PVIF4%,30yrs.
$52.5017.292$1,000(0.308)
$907.83$308$1,215.83
(b) 7%,10years,YTMof8%:
Price $35PVIFA4%,20yrs.$1,000PVIF4%,20yrs.
$3513.590$1,000(0.456)
$475.65$456$931.65
(c) 12%,20years,YTMof10%:
Price $60PVIFA5%,40yrs.$1,000PVIF5%,40yrs.
$6017.159$1,000(0.142)
$1,029.54$142$1,171.54
Bondpricesusingannualcompounding:
(a) 10%,15years,YTMof8%:
Price $105PVIFA8%,15yrs.$1,000PVIF8%,15yrs.
$1058.559$1,000(0.315)
$898.70$315$1,213.70
(b) 7%,10years,YTMof8%:
Price $70PVIFA8%,10yrs.$1,000PVIF8%,10yrs.
$706.710$1,000(0.463)
$469.70$463$932.70
(c) 12%,20years,YTMof10%:
Price $120PVIFA10%,20yrs.$1,000PVIF10%,20yrs.
$1208.514$1,000(0.149)
$1,021.68$149$1,170.68
Thepricedifferenceusingthetwocompoundingmethodsare:
Semiannual
Annual
Difference
(a)
Premium
$1,215.83
1,213.70
$2.13
(b)
Discount
$931.65
932
.70
$1.05
(c)
Premium
$1,171.54
1,170
.68
$0.86
Overall,thedifferencebetweenbondpricescomputedusingeithermethodareverysmall,rangingin
absolutevaluefrom$0.86to$2.13.Astheabovecomparisondemonstrates,ifabondsellsata
premiumitsvalueishigherwithsemiannualcompounding.Whenitsellsatadiscount,itsvalueis
greaterwithannualcompounding.
3.
PVIFA9%,15periods8.061
PVIF9%,15periods0.275
Bondprice($758.061)($1,0000.275)$604.58$275$879.57
Chapter11BondValuation208
4.
PVIFA4%,40periods19.793
PVIF4%,40periods0.208
Bondprice($5019.793)($1,0000.208)$989.65$208$1,197.65
5.
Returninterestincomepluspriceappreciation
Return$100$50$150
Holdingperiodreturn$150/$9000.1667or16.67%.
6.
Currentyieldisequaltoannualincomedividedbycurrentprice
$80/$1,1500.0696or6.9%.
7.
Priceofbondtoday(8%,18years,10%yield):
Price $80PVIFA10%,18yrs.$1,000PVIF10%,18yrs.
$808.201$1,000(0.180)
$656.08$180$836.08
Priceofbondinoneyear(8%,17years,9%yield):
Price $80PVIFA9%,17yrs.$1,000PVIF9%,17yrs.
$808.544$1,000(0.231)
$683.52$231$914.52
Iftheinvestorsexpectationsareaccurate,thepriceofthebondshouldgoupby$78.44($914.52)
$836.08)overthenextyear.Theholdingperiodreturnwillbe:
HPR Annualinterestincome
Capitalgains
Purchaseprice
$80 $78.44
18.95%
$836.08
8.
$1,170.68(1,000PVIFx%,20periods)($120PVIFAx%,20periods)
Using20yearsand10%
($1,0000.149)($1208.514)$149$1,021.68$1,170.68
Calculatorsolution:
20N,1170.58PV,120PMT,1000FV
CPTI/Y10.0%
9.
$1,098.62(1,000PVIFx%,20periods)($90PVIFAx%,20periods)
Using20yearsand8%
($1,0000.215)($1209.818)$215$883.62$1,098.62
Calculatorsolution:
20N,1098.62PV,90PMT,1000FV
CPTI/Y8.0%
209Gitman/JoehnkFundamentalsofInvesting,NinthEdition
10. Currentyield
Annualinterestincome
Currentmarketpriceofbond
$100 *
8.33%
$1, 200
*Annualinterestincome0.10$1,000(assumedfacevalue).
Usingannualcompounding,thepromisedyield(YTM)onthebondcanbecalculatedasfollows:
Currentprice:$1,200
CouponPayment:$100
Holdingperiod25years
FuturePrice$1,000
Letr%bethepromisedyield.Wehavethefollowing:
1,200100PVIFAr%,25period$1,000PVIFr%,25period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,thepromised
yieldis:8.1%
UsingSemiAnnualCompounding,thepromisedyield(YTM)onthebondcanbecalculatedas
follows:
Currentprice:$1,200
CouponPayment:$100250
Holdingperiod25years250periods
FuturePrice$1,000
Letr%bethepromisedYield.Wehavethefollowing:
1,20050PVIFAr%,50period$1,000PVIFr%,50period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,thepromised
semiannualyieldis:4.06%
Hencetheannualpromisedyield4.06%28.12%
11. (a) Currentyield Annualinterestincome/Currentmarketpriceofthebond
$100
$1200
8.33%
YieldtoMaturity(usinginterpolation)foramarketpriceof$1200
PV@4%($50PVIFA4%,50periods)($1000PVIF4%,50periods)
$1215($5021.482)($100021.482)
PV@5%($50PVIFA5%,50periods)($1000PVIF5%,50periods)
$999($5018.256)($10000.087)
InterestRate
4%
I
5%
BondPrice
$1215
1200
$999
$15difference
$216difference
Chapter11BondValuation210
YTM4%(15/216)(1%)4%0.07%4.07%28.14%
YieldtoCall
PV@3%
$1226.30
PV@4%
$1132.25
($50PVIFA3%,10periods)($1075PVIF3%,10periods)
($508.530)(10750.744)426.50799.80
($50PVIFA4%,10periods)($1075PVIF4%,10periods)
($508.111)($10750.676)405.55726.70
InterestRate
3%
I
4%
BondPrice
$1226
1200
$1132
$26difference
$94difference
YTC3%(26/94)(1%)4%0.277%3.287%26.56%
Thus,theYTConthisbondis6.56%whiletheYTMis8.14%.Bondtraderswouldcompare
bothrates.Sincetheconventionistousethelowermoreconservativemeasureofyieldasthe
appropriateindicatorofvalue,wewouldusetheYTCof6.56%.CalculatorSolution:
CalculatorSolution:
YTM:50N,1200PV,50PMT,1000FV;CPTI/Y4.0628.12%
YTM:10N,1200PV,50PMT,1075FV;CPTI/Y3.2726.54%
$100
$850
11.8%
(b) CurrentYield
YieldtoMaturity(usinginterpolation)foramarketpriceof$850
PV@5%
$999.80
PV@6%
$842.10
($50PVIFA5%,50periods)($1000PVIF5%,50periods)
($5018.256)($10000.087)
($50PVIFA6%,50periods)($1000XPVIF6%,50periods)
($5015.762)($10000.054)
InterestRate
5%
I
6%
BondPrice
$999
$149difference
850
$842
$157difference
YTM5%(149/157)(1%)5%0.95%5.95%211.9%
211Gitman/JoehnkFundamentalsofInvesting,NinthEdition
YieldtoCall(usinginterpolation)foramarketpriceof$850
PV@7%
$897.30
PV@8%
$833.23
($50PVIFA7%,10periods)($1075PVIF7%,10periods)
($507.024)($10750.508)
($50PVIFA8%,10periods)($1000PVIF8%,10periods)
($506.710)($10750.463)
InterestRate
7%
I
8%
BondPrice
$897
$47difference
850
$833
$64difference
YTC7%(47/64)(1%)7%0.734%7.73%215.46%
CalculatorSolution:
YTM:50N,850PV,50PMT,1000FV;CPTI/Y5.94211.9%
YTM:10N,850PV,50PMT,1075FV;CPTI/Y7.73215.47%
12. BondA:
Since10.5%isaninterestratethatdoesnotappearinthetables,itisnecessarytouseacalculatorto
pricethebond.
N20240semiannualperiods
I/Y10.5/25.25percentpersemiannualperiod
PMT0.09($1,000)/2$45persemiannualperiod
FV$1000
ComputePV$875.59
Currentyield
90
10.3%
$876
YieldtoMaturity
PV@5%
914
PV@6%
774
$45PVIFA5%,40period$1000PVIF5%,40period
(4517.159)(10000.142)
$45PVIFA6%,40period$1000PVIF6%,40period
(4515.046)(10000.097)
InterestRate
5%
I
6%
BondPrice
$914
$38difference
876
$774
$140difference
YTM5%(38/140)(1%)5%0.27%5.27%210.54%
Chapter11BondValuation212
YieldtoCall(usinginterpolation)foramarketpriceof$876
PV@6%
$917
PV@7%
$849
($45PVIFA6%,40periods)($1000PVIF6%,40periods)
($457.360)($10500.558)331.20585.90
($45PVIFA7%,10periods)($1050PVIF7%,10periods)
($457.024)($10500.508)316.08533.40
InterestRate
6%
I
7%
BondPrice
$917
876
$849
$41difference
$68difference
YTC6%(41/68)(1%)6%0.60%6.60%213.2%
BondB:
Since7.5%isaninterestratethatdoesnotappearinthetables,itisnecessarytouseacalculatorto
pricethebond.
N20annualperiods
I/Y7.5percentperyear
PMT$80peryear
FV$1000
ComputePV$1,050.97
Currentyield
7.6%
$80
$1,051
YieldtoMaturity(usinginterpolation)foramarketpriceof$1051
PV@7%
1105.52
PV@8%
1000.44
YTM
$80PVIFA7%,20period$1000xPVIF7%,20period
(8010.594)(10000.258)
$80PVIFA8%,20period$1000PVIF8%,20period
(809.818)(10000.215)
7%(54.52/105.08)1%7%052%7.52%
YieldtoCall(usinginterpolation)foramarketpriceof$1051
PV@7%
$1076.65
PV@8%
$1034.49
($80PVIFA7%,5periods)($1050PVIF7%,5periods)
($804.100)($10500.713)328748.65
($80PVIFA8%,5periods)($1050PVIF8%,5periods)
($803.993)($10500.681)319.44715.05
YTC
7%(25.65/42.16)(1%)7%0.61%7.61%
13. PVIFPrice/Par0.209.PVIFof0.209for15years11%.
CalculatorSolution:
15N,209PV,1000FV;CPTI/Y11.0%
213Gitman/JoehnkFundamentalsofInvesting,NinthEdition
14. PriceParPVIF$1,0000.422$422.00.
CalculatorSolution
10N,9I/Y,1000FV;CPTPV$422.41
15. Bondterms:25years,zerocoupon,pricedat11.625(priceof$116.25).
Currentyield
Annualinterestincome
Currentmarketpriceofbond
$0
$116.25
Theeasiest(andmostaccurate)waytofindthepromisedyieldofazerocouponissuewithouta
calculatorthathasthetimevalueofmoneyfunctionistousethetableofpresentvalueinterestfactors
(TableB.3intheappendix).FirstsolveforthePVIFinthebasicpresentvalueequation:
$116.25 $1,000PVIF
PVIF
$116.25
0.116
$1,000
The25yearfactorinTableB.3thatsequal(orclose)to0.116is9%,whichliesattheintersectionof
25yearsand9%.(Note:Usingtheapproximateyieldequationresultsinapromisedyieldofonly
6.33%,afigurethatisntevenclosetotherealpromisedyieldwhichillustrateswhyapproximate
yieldisnotaveryaccuratemeasureofreturnforzerocouponbonds.)
CalculatorSolution
25N,116.25PV,1000FV;CPTI/Y8.99%
Tofindthepriceofthiszerocouponbond,findthepresentvalueat12%of$1,000(parvalue)in25
years:
Bondprice $1,000PVIF12%,25yrs.
$1,0000.059$59
CalculatorSolution:
25N,12I/Y,1000FV;CPTPV$58.82
16. Usingannualcompounding,therealizedyieldonthebondcanbecalculatedasfollows:
Currentprice:$800
CouponPayment:$80
Holdingperiod3years
FuturePrice$950
Letr%bethepromisedyield.Wehavethefollowing:
95080PVIFAr%,3period$950PVIFr%,3period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,therealized
yieldis:15.38%
Ifthisisaninemonthholdingperiod,theholdperiodreturnis:
HPR
Chapter11BondValuation214
The15.38%islowerthanthe26.25%holdingperiodreturn.Thelatterisforninemonths,whilethe
formerisanannualyield.Dividingtheninemonthholdingperiodby0.75putsbothratesonan
annualbasis;thatis,26.25/0.7535%annualrateofreturn.
215Gitman/JoehnkFundamentalsofInvesting,NinthEdition
Chapter11BondValuation216
Durationanalysis:10%coupon,20years,8%YTM
(1)
Year
(t)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
(2)
Weighted
Annual
CashFlow
(C)
$100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
1,100
(3)
PVIF
(8%)
0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.292
0.270
0.250
0.232
0.215
(4)
PresentValue
ofCashFlows
(2)(3)
$92.60
85.70
79.40
73.50
68.10
63.00
58.30
54.00
50.00
46.30
42.90
39.70
36.80
34.00
31.50
29.20
27.00
25.00
23.20
236.50
(5)
PC(Ct)
Dividedby
CurrentPrice
oftheBond
4/$1,196.80
0.07737
0.07161
0.06634
0.06141
0.05690
0.05264
0.04871
0.04512
0.04178
0.03869
0.03585
0.03317
0.03075
0.02841
0.02632
0.02440
0.02256
0.02089
0.01939
0.19761
Duration
(6)
Time
Relative
CashFlow
(1)(5)
0.07737
0.14322
0.19902
0.02564
0.28450
0.31584
0.34097
0.36096
0.37602
0.38960
0.39435
0.39804
0.39975
0.39774
0.39480
0.39040
0.38352
0.37602
0.36841
3.95220
10.19years
217Gitman/JoehnkFundamentalsofInvesting,NinthEdition
Modifiedduration
Durationinyears
1 Yieldtomaturity
10.19
9.44
1 0.08
%changeinbondprice 1Modifieddurationchangeininterestrates
19.441%9.44%
Ifmarketyieldsrise1%,thepriceofthebondwillfallby9.44%:
Priceinoneyear $100PVIFA9%,19yrs.$1,000PVIF9%,19yrs.
$1008,950$1,0000.194
$895$194$1,089
Thechangeinbondpriceis$107.80,or9%ofthepurchaseprice.Thechangeinpriceusingthe
modifieddurationmethodis9.44%,overstatingtheactualpricechangeby0.44%.Durationis
thereforenotagoodpredictorofpricevolatilityifinterestratesundergoabigswing.Sincetheprice
yieldrelationshipofabondisconvexinformbutdurationisnotthedurationmeasurewill
overstatethepricedeclineasthemarketexperiencesabigincreaseinrates.Here,althoughbetter,the
modifieddurationoverstatedthedeclinebyalmost0.5%.
22. Thisquestionisaboutbondpricevolatility.Weneedtomeasuretheresponsivenessofabondsprice
toagivenchangeinmarketinterestrates.Tomaximizecapitalgains,weneedtoselectthebondthat
hasthemaximumpricevolatility.Todothis,firstcalculatethemodifieddurationofeachbondusing
thefollowingformula:
Modifiedduration
Durationinyears
1 Yieldtomaturity
Thencalculatethepricechangewiththefollowingformula:
%changeinbondprice1Modifieddurationchangeininterestrates
(a) Bondwithdurationof8.46yearswithYTMof7.5%:
Modifiedduration
8.46
7.87%
1 0.075
%changeinbondprice 17.870.5%3.94%
(b) Bondwithdurationof9.30yearswithYTMof10%:
9.30
8.45%
1 0.10
%changeinprice 18.450.5%4.23%
Modifiedduration
(c) Bondwithdurationof8.75yearswithYTMof5.75%:
8.75
8.27%
1 0.0575
%changeinprice 18.270.5%4.135%
Modifiedduration
Bond(b)offersthepotentialformaximumcapitalappreciation.Tomaximizegains,thisbondshould
beselectedovertheothers.
Chapter11BondValuation218
(Note:Thisquestioncanbeanswereddirectlybylookingatthemodifiedduration.Foragiven
changeininterestrates,thebondwiththehighestmodifieddurationwilloffermaximumprice
appreciationpotential.Bond(b),withthehighestmodifiedduration,isthechoicefortheinvestor
whowishestomaximizecapitalgains.
23. Currentpriceofthebondsat9%marketinterest:
Zerocouponbond:
Price$1,000PVIFA9%,25yrs.$1,0000.116$116
7%,20yearbond(assumeannualpayments):
Price $75PVIFA9%,20yrs.$1,000PVIFA9%,20yrs.
$759.129$1,0000.178$862.68
Pricesbasedon7%ratein1year:
Zerocouponbond:
Price$1,000PVIFA7%,24yrs.$1,000.197$197
7%,19yearbond(assumeannualpayments):
Price $75PVIFA7%,19yrs.$1,000PVIFA7%,19yrs.
$7510.336$1,000.277$1,052.20
Capitalgains:
Zerocouponbond:Gain$197$116$81
7%bond:
Gain$1,052.20862.68$189.52
Tomaximizecapitalgainsperbond,buythe7%,20yearbond;butthisdoesnttakeintoaccount
thebigdifferenceintheamount(cost)invested.Todothat,weshouldcompareholdingperiod
returns:
HPR
Zerocouponbond:
7%bond:
Interest Capitalgains
Purchaseprice
$81
69.8%
$116
$75 $189.52
30.7%
HPR
$862.68
HPR
Theconclusionremainsunchanged.Maryshouldpurchasethezerocouponbond.
WeknowfromChapter9thatpricesofbondswithlowercouponsand/orlongermaturitieswill
respondmorevigorouslytochangesinmarketrates.Thisisexactlywhythezerocouponbond
providedbettercapitalgainsthanthe7%bondasmarketrateswentdown;thezerocouponbond
paysnointerestand,inthiscase,hadalongermaturitythantheotherbond.
Thedurationofazerocouponbondisequaltoitsactualmaturity,whilethedurationofacoupon
bearingbondisalwayslessthanitsactualmaturity.Inthiscase,thezerocouponbondsdurationis
longer(25years)thanthatofthe7%couponbond.Thezerocouponbond,withitslongerduration,
shouldbemorepricevolatilethantheotherbondunderconsideration.
219Gitman/JoehnkFundamentalsofInvesting,NinthEdition
24. ThedurationandmodifieddurationcanbecalculatedusingtheIMDsoftware.Itgivestheprecise
durationmeasurebecauseitavoidstheroundingofferrorswhichareinevitablewithmanual
calculations.ThefollowinganswersarecomputedusingaLotus123worksheetsetuptomimic
manualcalculationsusingpresentvaluefactorsfromtableB.3.Thedurationandmodifiedduration
measuresusingIMDareprovidedforcomparison.
(a) Durationandmodifiedduration
T
[PV(Ct ) t ]
Duration
Pbond
t 1
Modifiedduration
Durationinyears
1 Yieldtomaturity
Bond1:13years,8,pricedtoyield7.47%
UsingLotus123,durationofthisbondis8.74.years
8.74
8.13
1 0.0747
Usingthesoftwarethedurationis8.58yearsandthemodifieddurationis7.97%.
Modifiedduration
Bond3:20years,zerocoupon,pricedtoyield8.22%
Withazerocouponbond,thedurationofthisbondisthesameasitsmaturity,20years.
20.00
18.48
Modifiedduration
1 0.0822
Chapter11BondValuation220
Bond4:24years,7,pricedtoyield7.90%
UsingLotus123,durationofthisbondis11.59.years
11.59
10.70
Modifiedduration
1 0.0790
Usingthesoftwarethedurationis11.56yearsandthemodifieddurationis10.72%
(b) WhenElliotinvests$250,000ineachofthefourbonds,theweightedaveragedurationofthe
portfoliois:
(1)
(2)
(3)
Bond1
Bond2
Bond3
Bond4
Bond
Particulars
13years,8.15%
15years,7.875%
20years,0%
24years,7.5%
Amount
Invested
$250,000
250,000
250,000
250,000
$1,000,000
(4)
Weight
0.25
0.25
0.25
0.25
1.00
(5)
Bond
Duration
8.74
9.41
20.00
11.59
(6)
Weighted
Duration
(4)(5)
2.1850
2.3525
5.0000
2.8975
12.4350
Thedurationoftheportfoliois12.44years.
(c) WhenElliotinvests$360,000eachintobonds1and3,and$140,000eachintobonds2and4,the
weightedaveragedurationofthebondportfoliois:
(1)
(2)
Bond1
Bond2
Bond3
Bond4
Bond
Particulars
13years,8.25%
15years,7.875%
20years,0%
24years,7.5%
(3)
Amount
Invested
$360,000
140,000
360,000
140,000
$1,000,000
(4)
Weight
0.36
0.14
0.36
0.14
1.00
(5)
Bond
Duration
8.74
9.41
20.00
11.59
(6)
Weighted
Duration
(4)(5)
3.1464
1.3174
7.2000
1.6226
13.2864
Thedurationoftheportfoliois13.29years.
(d) Portfolio(c)hasahigherdurationthanportfolio(b).Ifratesareabouttorise,thenitissaferto
investinportfolio(b),becausethiswouldbelesspricevolatilethantheotherportfolio.
.8
221Gitman/JoehnkFundamentalsofInvesting,NinthEdition
2. Thepriceofthebondin2years(whenithas23yearstomaturity):
Priceofbond Coupon(PVIFA)Maturityvalue(PVIF)
$75PVIFA8%,23yrs.$1,000PVIF8%,23yrs.
$7510.371$1,0000.170
$778$170948
3. Usingtheformulaforexpectedreturn
Currentprice:$852
CouponPayment:$75
Holdingperiod2years
FuturePrice$948
Letr%betheYieldToMaturity.Wehavethefollowing:
85275PVIFAr%,2period$948PVIFr%,2period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theYTM
is14%
4. Althoughthisappearstobeanattractiveinvestment,onemustcomparetheexpectedreturnwith
otherpossiblealternatives.Presumingtheexpectedrateofreturn(of14%)iscommensuratewith
theexposuretorisk,Kelley&Erinshouldseriouslyconsiderthisbondinvestmentopportunity
unlesstheyfeelstronglythattheycandobetterelsewhere.Further,theyshouldbewellawareof
thefactthatthishighrateofreturnisdueinlargeparttotheirabilitytocorrectlyforecastinterest
rates(noeasytask);theyshouldfullyappreciatetheimplicationsofthiskindofriskexposure.
(b) 1. Wewillevaluatethecurrentandpromisedyieldsusingthetextsformulas.
CurrentyieldAnnualinterest/Currentprice
BetaCorporation
$70/$785
8.92%
DentalFloss,Inc
$75/$780
9.60%
RootCanalProducts
$65/$885
7.35%
KansasCityDental
$80/$950
8.42%
Insurance
BetaCorporation:
78535PVIFAr%,30period$1,000PVIFr%,30period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:4.87%29.75%
DentalFloss,Inc:
78037.50PVIFAr%,30period$1,000PVIFr%,30period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:5.21%210.42%
RootCanalProducts:
88533.50PVIFAr%,26period$1,000PVIFr%,26period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:4%28%
Chapter11BondValuation222
KansasCityDentalInsurance:
95040PVIFAr%,34period$1,000PVIFr%,34period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:4.28%28.56%
2. Clearly,DentalFlossoffersbothhighercurrentandpromisedyieldsthanBetaCorporation.
3. TheCoatesshouldswapBetaforDentalFlosstoobtainhighercurrentincomeandpromised
yield;thispresumesthetwohaveequaldefaultrisk,andthattheCoatesaresurethetwoareof
comparablequality.
Annualinterestincome
Currentmarketpriceofbond
Bond1:12years,7%coupon;currentlypricedat$895
Currentyield
$75
8.38%
$895
YieldtoMaturity:89575PVIFAr%,12period1,000PVIFr%,12period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:8.96%
Bond2:10years,zerocoupon;currentlypricedat$405
Currentyield0%forazerocouponbond
Preciseyield:SolveforPVIF:
$405 $1, 000 PVIF
$405
PVIF
0.405
$1, 000
The10yearfactorclosestto0.405(fromTableB.3)occurat9%(0.422)and10%(0.386).Because
0.405ishalfwaybetweenthetwo,thepromisedyieldonthissecurityshouldbe9.5%.
Usingthesoftware,theYTMis9.45%.
Bond3:10years,10%coupon;currentlypricedat$1,080
Currentyield
$100
9.26%
$1,080
YieldtoMaturity:1,080100PVIFAr%,10period1,000PVIFr%,10period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:8.77%
223Gitman/JoehnkFundamentalsofInvesting,NinthEdition
Bond4:15years,9%coupon;currentlypricedat$980
Currentyield
$97.50
9.95%
$980.00
YieldtoMaturity:98097.50PVIFAr%,15period1,000PVIFr%,15period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:10%
(b) DurationandPriceVolatility
Bond1:12years,7%coupon;currentlypricedat$895toyield9%
UsingLotus123,durationofthisbondis8.07years
8.07
7.40
1 0.09
Percentchangeinbondprice1ModifieddurationChangeininterestrate
Modifiedduration
17.400.75
5.55%
Thepriceofthebondwillfallby5.55%ifinterestraterise0.75%andviceversa.
Bond2:10years,zerocoupon;currentlypricedat$405toyield9.5%
Thedurationofazerocouponbondisthesameasitsmaturity,or10years.
Modifiedduration
10.00
9.13
1 0.095
Percentchangeinbondprice1ModifieddurationChangeininterestrate
19.130.75
6.85%
Thepriceofthebondwillfallby6.85%ifinterestraterise0.75%andviceversa.
Bond3:10years,10%coupon;currentlypricedat$1,080toyield8.75%
UsingLotus123,durationofthisbondis6.89years.
Modifiedduration
6.89
6.34%
1 0.0875
Percentchangeinbondprice1ModifieddurationChangeininterestrate
16.340.75
4.76%
Thepriceofthebondwillfallby4.76%ifinterestraterise0.75%andviceversa.
Chapter11BondValuation224
Bond4:15years,9%coupon;currentlypricedat$980toyield10%
UsingLotus123,durationofthisbondis8.41years.
8.41
7.65%
1 0.10
Percentchangeinbondprice1ModifieddurationChangeininterestrate
1.650.75
5.74%
Modifiedduration
Thepriceofthebondwillfallby5.74%ifinterestraterise0.75%andviceversa.
(c) WhenGraceinvests450,000ineachofthefourbonds,theweightedaveragedurationofthebond
portfoliowouldbe:
(1)
Bond1
Bond2
Bond3
Bond4
(2)
Bond
Particulars
12years,7.50%
10years,zero
10years,10%
15years,9.75%
(3)
(4)
Amount
Invested
$50,000
50,000
50,000
50,000
$200,000
Weight
0.25
0.25
0.25
0.25
1.00
(5)
Bond
Duration
8.07
10.00
6.89
8.41
(6)
Weighted
Duration
(4)(5)
2.0175
2.5000
1.7225
2.1025
8.3425
Thedurationoftheportfoliois8.34years.Gracesinvestmenthorizonis7years;therefore,thebond
portfolioisnotimmunizedbecausetheweightedaverageoftheportfolioisgreaterthantheinvestment
horizon.
(d) Thebondwiththehighestdurationisthezerocouponbond(10years).Thebondwiththelowest
durationisthe10%,10yearbond.Tolengthentheportfoliosduration,Gracecaninvestinhigher
durationbondsandshortenthedurationbyinvestinginlowerdurationbonds.Byinvestingtheentire
sumof$200,000inthe10yearbond,shecanachievetheshortestdurationportfolio.Obviously,
investingtheentireportfoliointhezerocouponbondresultsinthelongestdurationportfolio.
(e) Graceisplanningtocashoutofthebondportfolioinabout7yearsandwantstoimmunizethe
portfolio.Todoso,wemustfindaportfoliowithaweightedaveragedurationof7years.Theeasiest
waytoimmunizeherportfoliofrominterestrateriskistoinvestallofthe$200,000inthe10year,
10%bond,withits6.89yearduration.
Toachieveafullyimmunizedportfoliowithadurationofexactly7years,wecanconsiderthe12
year,7.50%bondwithits8.07yeardurationandthe10year,10%bondwithits6.89yearduration.
Thefollowingportfoliohasa7.01yeardurationandisthereforeimmunizedfrominterestraterisk:
(1)
Bond1
Bond2
(2)
Bond
Particulars
12years,7.50%
10years,10%
(3)
Amount
Invested
$20,000
180,000
(4)
Weight
0.10
0.90
1.00
(5)
Bond
Duration
8.07
6.89
(6)
Weighted
Duration
(4(5)
0.8070
6.2010
7.0080
225Gitman/JoehnkFundamentalsofInvesting,NinthEdition
(f) RegardlessofhowGraceimmunizesherbondportfolio,immunizationisnotmeanttobeapassive
strategythatshecanputawayandforgetabout.Immunizationisacontinuedportfoliorebalancing
processthatreflectschangesinmarketinterestrates.
.9
Outside Project
Chapter 11RealizedReturnsonBondsvs.TheirPromisedYields
Whatkindofreturnshaveinvestorsearnedlately?Howdolastyearsrealizedreturnsstackupagainstthe
yields(i.e.,yieldstomaturity)promisedatthetimeofpurchase?Realizedreturnsonbondsareofinterest
toinvestorsbecausepastperformancemaygivecluestothecurrenttrendsandmaysuggestpossibletrend
shifts.Thepurposeofthisprojectistolookatholdingperiodreturnsforthepastyearonbonds.
ObtainaWallStreetJournalthatsapproximatelyoneyearold,andselectfourcorporatebondsthatare
tradedontheNewYorkStockExchange(makesuretheyrenonconvertible).Selectmaturitiesof5years,
10years,15years,and20years.Recordtheprices,coupons,andmaturitiesofyourfourbonds;also
determinethepromisedyieldforeachissue.Now,lookupthesamebondstoday.Calculatetheholding
periodreturnactuallyrealizedforeachsecurityoverthepastyear.Notetheeffectofcouponandmaturity
oneachbondsreturn.Contrastthepromisedyieldofeachbondwithitsrealizedreturn.Howdoyou
explainthedifference?