Learning Management System

Subject Name

Investment Decision

Week

Topic

Bond Valuation

Name : .... Lecturer : .................................

Intake : ......... Date

: .........

1.

The three factors affecting the price of a bond are coupon, yield, and term to maturity.
The relationship between price and coupon is a direct one - the higher the coupon, the
higher the price.
The relationship between price and yield is an inverse one - the higher the yield the lower
the price, all other factors held constant.
The relationship between price and maturity is not so clearly evident. Price changes
resulting from changes in yields will be more pronounced than the longer the term to
maturity.

2.
a) Given that you expect interest rates to decline during the next six months, you should
choose bonds that will have the largest price increase, that is, bonds with long
durations.
b) Case 1: Given a choice between bonds A and B, you should select bond B, since
duration is inversely related to both coupon and yield to maturity.
Case 2: Given a choice between bonds C and D, you should select bond C, since
duration is positively related to maturity and inversely related to coupon.
Case 3: Given a choice between bonds E and F, you should select bond F, since
duration is positively related to maturity and inversely related to yield to maturity.
3.
a) UsingafinancialcalculatortheYTMis12.685%.Thecorrectnessofthisnumberis

provenbyputtingtheYTMinthebondvaluationmodel.Thisproofisasfollows:
B0
B0
B0
B0

120(PVIFA12.685%,15)1,000(PVIF12.685%,15)
$120(6.569)$1,000(0.167)
$788.28167
$955.28

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SinceB0is$955.28andthemarketvalueofthebondis$955,theYTMisequaltothe
ratederivedonthefinancialcalculator.
b) Themarketvalueofthebondapproachesitsparvalueasthetimetomaturitydeclines.
Theyieldtomaturityapproachesthecouponinterestrateasthetimetomaturity
declines.
P

4.
P

40
40
40
1,040

....
1,041 .58
0.07
0.07 2
0.07 3
0.07 10
(1
) (1
)
(1
)
(1
)
2
2
2
2
40
40
40
1,040

....
960 .44
0.09
0.09 2
0.09 3
0.09 10
(1
) (1
)
(1
)
(1
)
2
2
2
2

When the coupon rate is higher than the YTM, the bond sells at a premium, but when the
coupon rate is lower than the YTM, the bond sells at a discount. This problem also illustrates
the general inverse relationship between bond prices and interest rates.
5.
t
1
2
3
4
5

CF
40
40
40
40
40

PV
38.10
36.28
34.55
32.91
31.34

1040

776.06
949.24

Macaula
y

Duratio
n

5.43

PV(t)
38.10
72.56
103.66
131.63
156.71
4656.3
8
5159.0
4
(semiannual period) or 2.72 years

a) Modified duration = 2.72 / (1+(0.1/2)) = 2.59 years

b) % change in price = -Dmod x i
= -2.59 x 0.50
= 1.294%

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The bond price should increase by 1.294% in response to a drop in the bonds YTM
from 10% to 9.5%. If the price of the bond before the decline was $949.24, the price
after the decline in the YTM should be approximately $949.24 x 1.01294 = $961.52.

6.

For option-free coupon bonds, modified duration is a better measure of the bonds
sensitivity to changes in interest rates. Maturity considers only the final cash flow, while
modified duration includes other factors. These factors are the size of coupon payments,
the timing of coupon payments, and the level of interest rates (yield-to-maturity).

7.
Years to maturity = n = 10
Coupon rate = C = 8%
Annual coupon = $1,000 0.08 = $80
Current market rate = i = 6%
Present value of bond = PB
0 6% 1

10

$80

$80

$80

$80

$80

$80

$80
$1,000

PB

C1
C2
C3
C F

10 10
1
2
3
(1 i )
(1 i )
(1 i )
(1 i )

1
1

F
$1,000
(1 i )
(1.06)10
C

$
80

n
i
0.06 (1.06)10

(1 i )

$588.81 $558.39 $1,147.20

8.
0

7.25%

$55

$55

$55

$55

$1,055

Coupon rate = C = 5.5%

Annual coupon = $1,000 0.055 = $55
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Current market rate = i = 7.25%

Present value of bond = PB

1
1

1
5
1 (1 i ) n

F
$1,000
(1.0725)
PB C
$55


n
i
0.0725 (1.0725) 5

(1 i )

$224.01 $704.72 $928.72

9.
Years to maturity = n = 3
Coupon rate = C = 6.1%
Frequency of payment = m = 2
Semiannual coupon = $1,000 (0.061/2) = $30.50
Current market rate = i = 5.8%
Present value of bond = PB
0 5.8%

$30.50 $30.50 $30.50 $30.50 $30.50 $30.50

$1,000

PB C
2

1
1 i

2n

F
1 i

$165.77 $842.38 $1,008.15

2n

1
1 (1.029) 6
$30.50
0.029

$1,000
(1.029) 6

10.
Years to maturity = n = 7
Coupon rate = C = 12%
Annual coupon = $1,000 x 0.12 = $120
Current market rate = i = 8.875%
Present value of bond = PB
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$120

$120

$120

$120

$120

$120

$120
$1,000

1
1

1
7
1 (1 i ) n

F
$1,000
(1.08875)
PB C
$120


n
i
0.08875 (1.08875) 7

(1 i )

$606.50 $551.14 $1,157.94

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