Chapter10TheBondMarket77

Bonds Problems
1.

Abondpays$80peryearininterest(8%coupon).Thebondhas5yearsbeforeitmaturesatwhich
timeitwillpay$1,000.Assumingadiscountrateof10%,whatshouldbethepriceofthebond
(ReviewChapter3)?

2.

Azerocouponbondhasaparvalueof$1,000andmaturesin20years.Investorsrequirea10%
annualreturnonthesebonds.Forwhatpriceshouldthebondsell?(note,zerocouponbondsdonot
payanyinterest)(ReviewChapter3)?

3.

Considerthetwobondsdescribedbelow:
Maturity
CouponRate
(Paidsemiannually)
ParValue

BondA BondB
15yrs
20yrs
10%
6%
$1,000

$1,000

(a) Ifbothbondshadarequiredreturnof8%,whatwouldthebondspricesbe?
(b) Describewhatitmeansifabondsellsatadiscount,apremium,andatitsfaceamount(par
value).Arethesetwobondssellingatadiscount,premium,orpar?
(c) Iftherequiredreturnonthetwobondsroseto10%,whatwouldthebondspricesbe?
Problemsolutionforendofchapterandstudyguide
1. $924.18
2. $148.64
3. (a) BondA$1,172.92
BondB$802.07
(b) BondAissellingatapremium
BondBissellingatadiscount
(c) BondA$1,000
BondB$656.82
4.

A2year$1,000parzerocouponbondiscurrentlypricedat$819.00.A2year$1,000annuityis
currentlypricedat$1,712.52.Ifyouwanttoinvest$10,000inoneofthetwosecurities,whichisa
betterbuy?Youcanassume
(1) thepureexpectationstheoryofinterestratesholds,
(2) neitherbondhasanydefaultrisk,maturitypremium,orliquiditypremium,and
(3) youcanpurchasepartialbonds.
Solution: WithPV$819,FV$1,000,PMT0andN2,theyieldtomaturityonthetwoyear
zerocouponbondsis10.5%forthetwoyearannuities,PV$1,712.52,PMT0,FV
$2,000andN2givesayieldtomaturityof8.07%.Thezerocouponbondsarethebetter
buy.

Chapter10TheBondMarket78

5.

Considerthefollowingcashflows.Allmarketinterestratesare12%.
Year
CashFlow

1
160

2
170

3
180

4
230

(a) Whatpricewouldyoupayforthesecashflows?Whattotalwealthdoyouexpectafter2years
ifyouselltherightstotheremainingcashflows?Assumeinterestratesremainconstant.
(b) Whatisthedurationofthesecashflows?
(c) Immediatelyafterbuyingthesecashflows,allmarketinterestratesdropto11%.Whatisthe
impactonyourtotalwealthafter2years?
Solution: (a)

Price

160 170
180
230

552.67
2
3
1.12 1.12 1.12 1.12 4

ExpectedWealth 160 (1.12)1.5 170 (1.12)5

180
230

$733.69
5
1.12 1.121.5

(b)

160
170
180
230
(1)
(2)
(3)
2
3
1.12
1.12
1.124 2.50
Duration 1.12
552.67

(c)

ExpectedWealth 160 (1.11)1.5 170 (1.11).5

180
230

$733.74
.5
1.11 1.111.5

Sinceyouareholdingthecashflowsfortheirduration,youareessentiallyimmunized
frominterestratechanges(inthissimplisticexample).
6.

Theyieldonacorporatebondis10%anditiscurrentlysellingatpar.Themarginaltaxrateis20%.
Aparvaluemunicipalbondwithacouponrateof8.50%isavailable.Whichsecurityisabetterbuy?
Solution: Theequivalenttaxfreeratetaxableinterestrate*(1marginaltaxrate).Inthiscase,
0.10(10.20)8%.Thecorporatebondoffersaloweraftertaxyieldgiventhe
marginaltaxrate,sothemunicipalbondisabetterbuy.

7.

Ifthemunicipalbondrateis4.25%andthecorporatebondrateis6.25%,whatisthemarginaltax
rateassuminginvestorsareindifferentbetweenthetwobonds?
Solution: Theequivalenttaxfreeratetaxableinterestrate*(1marginaltaxrate).Inthiscase,
0.04250.0625*(1X),orX32%.

Chapter10TheBondMarket79

8.

A10year,1,000parvaluebondwitha5%annualcouponistradingtoyield6%.Whatisthecurrent
yield?
Solution: Thecurrentpriceofthebondiscomputedasfollows:
PMT50;N10;FV1000;I6
ComputePV;PV926.40
Thecurrentyield50/926.405.4%

9.

A$1,000parbondwithanannualcouponhasonly1yearuntilmaturity.Itscurrentyieldis
6.713%anditsyieldtomaturityis10%.Whatisthepriceofthebond?
Solution: (1)
(2)

CY.06713Coupon/Price,orCoupon0.06713Price
Price(Coupon1000)/1.10.
Substitutingfrom(1),Price(0.06713Price1000)/1.10
SolveforPrice,Price$968.17

10. A1yeardiscountbondwithafacevalueof$1,000waspurchasedfor$900.Whatistheyieldto
maturity?Whatistheyieldonadiscountbasis?
Solution: 9001000/(1YTM),orYTM11.11%
YDB(1000900)/1000*(360/365)9.86%
11. A7year,$1,000parbondhasan8%annualcouponandiscurrentlyyielding7.5%.Thebondcanbe
calledin2yearsatacallpriceof$1,010.Whatisthebondyielding,assumingitwillbecalled
(knownastheyieldtocall)?
Solution: Thecurrentpriceofthebondiscomputedasfollows:
PMT80;N7;FV1000;I7.5
ComputePV;PV1,026.48
Usingthis,theyieldtocalliscalculatedasfollows:
PMT80;N2;FV1010;PV1,026.48
ComputeI;I7.018%

Chapter10TheBondMarket80

12. A20year$1,000parvaluebondhasa7%annualcoupon.Thebondiscallableafterthe10thyearfor
acallpremiumof$1,025.Ifthebondistradingwithayieldtocallof6.25%,thebondsyieldto
maturityiswhat?
Solution: Thecurrentpriceofthebondiscomputedusingtheyieldtocallasfollows:
PMT70;N10;FV1025;I6.25
ComputePV;PV1,068.19
Usingthis,theyieldtomaturityiscalculatedasfollows:
PMT70;N20;FV1000;PV1,068.19
ComputeI;I6.39%
13. A10year$1,000parvaluebondhasa9%semiannualcouponandanominalyieldtomaturityof
8.8%.Whatisthepriceofthebond?
Solution: Thepriceofthebondiscomputedasfollows:
PMT45;N20;FV1000;I8.8
ComputePV;PV1,013.12