Booth Cleary 2nd Edition Chapter 6 - Bond Valuation and Interest Rates

Chapter 6 Bond Valuation and Interest
Rates
INTRODUCTION TO
CORPORATE FINANCE
Second Edition

Laurence Booth W. Sean Cleary
Prepared by
Ken Hartviksen
Lecture Agenda
1. Basic Structure of Bonds
2. Bond Valuation
3. Bond Yields
4. Interest Rate Determinants
5. Other Debt Instruments
Bond Basics Valuation Yields Determinants Other Debt
Learning Objectives
The basic features of different types of bonds
How to value bonds given an appropriate discount rate
How to determine the discount rate or yield given the
market value of a bond
How market interest rates or yields affect bond investors
How bond prices change over time
The factors (both domestic and global) that affect interest
rates
Basic Structure of Bonds
The Basic Structure of Bonds
What is a bond?
In its broadest sense, a bond is any debt
instrument that promises a fixed income
stream to the holder
Fixed income securities are often classified
according to maturity, as follows:
Less than one year Bills or Paper
1 year < Maturity < 7 years Notes
< 7 years Bonds
A typical bond has the following characteristics:
A fixed face or par value, paid to the holder of the
bond, at maturity
A fixed coupon, which specifies the interest payable
over the life of the bond
Coupons are usually paid either annually or semi-
annually
A fixed maturity date
Bonds may be either:
Bearer bonds
Registered bonds
Bond indenture - the contract between the
issuer of the bond and the investors who hold it
The market price of a bond is equal to the
present value of the payments promised by the
bond

(See the basic pattern of cash flows from a traditional bond on the next
slide)
Cash Flow Pattern for a Traditional Coupon-Paying Bond

0 1 2 3 n

I I I I I
F

FIGURE 6-1
I = interest payments, and F = principal repayment
Cash Flow Pattern of a Bond
The Purchase Price or Market Price of a bond is simply the present
value of the cash inflows, discounted at the bonds yield-to-maturity
0 2
3
4 n 1
Coupon Coupon Coupon Coupon Coupon +
Face Value
Purchase
Price
Cash Inflows
to the Investor
Cash Outflows
to the Investor
Bond indenture is the contract between the
issuer and the holder. It specifies:
Details regarding payment terms
Collateral
Positive and negative covenants
Par or face value (usually increments of $1,000)
Bond pricing usually shown as the price per $100
of par value, which is equal to the percentage of the
bonds face value
Term-to-maturity the time remaining to the
bonds maturity date
Coupon rate the annual percentage interest
paid on the bonds face value; to calculate the
dollar value of the annual coupon, multiply the
coupon rate by the face value
If the coupon is paid twice a year, divide the annual
coupon by two
Example: A $1,000 bond with an 8% coupon rate will
have an $80 coupon if paid annually or a $40 coupon if
paid semi-annually

Security and Protective Provisions
Mortgage bonds secured by real assets
Debentures either unsecured or secured with
a floating charge over the firms assets
Collateral trust bonds secured by a pledge of
financial assets, such as common stock, other
bonds or treasury bills
Equipment trust certificates secured by a
pledge of equipment, such as railway rolling
stock
Security and Protective Provisions
Covenants
Positive covenants things the firm agrees to do
Supply periodic financial statements
Maintain certain ratios
Negative covenants things the firm agrees not to do
Restricts the amount of debt the firm can take on
Prevents the firm from acquiring or disposing of
assets
More Bond Features
Call feature allows the issuer to redeem or pay
off the bond prior to maturity, usually at a
premium
Retractable bonds allows the holder to sell the
bonds back to the issuer before maturity
Extendible bonds allows the holder to extend
the maturity of the bond
Sinking funds funds set aside by the issuer to
ensure the firm is able to redeem the bond at
maturity
Convertible bonds can be converted into
common stock at a pre-determined conversion
price
Bond Valuation
Bond Valuation
The value of a bond is a function of:
Par value
Term to maturity
Coupon rate
Investors required rate of return (discount rate is
also known as the bonds yield to maturity)
Bond Value
General Formula

) k (
F
k
) k (
I B
n
b b
n
b
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-1]
Where:
I = interest (or coupon ) payments
k
b
= the bond discount rate (or market rate)
n = the term to maturity
F = Face (or par) value of the bond
Bond Valuation: Example
What is the market price of a ten-year, $1,000 bond
with a 5% coupon, if the bonds yield-to-maturity is
6%?
( )
( )
( )
( )
10
10
1 1
1
1 1.06
1, 000
50
0.06
1.06
$926.40
n
b
n
b
b
k
F
B I
k
k
(
+
= + (
+
(

(
= + (
(

=
Calculator Approach:
1,000 FV
50 PMT
10 N
I/Y 6
CPT PV 926.40
Example
Factors Affecting Bond Prices
Bond Price-Yield Curve
Market Yield (%)
FIGURE 6-2
Price
($)
When interest rates increase, bond prices fall
The relationship between the coupon rate and the bonds
yield-to-maturity (YTM) determines if the bond will sell at
a premium, at a discount, or at par
If Then Bond Sells at a:
Coupon < YTM Market < Face Discount
Coupon = YTM Market = Face Par
Coupon > YTM Market > Face Premium
Bond Valuation: Semi-Annual Coupons
So far, we have assumed that all bonds have
annual pay coupons. While this is true for
many Eurobonds, it is not true for most
domestic bond issues, which have coupons
that are paid semi-annually
To adjust for semi-annual coupons, we must
make three changes:
Size of the coupon payment (divide by 2)
Number of periods (multiply by 2)
Yield-to-maturity (divide by 2)
Bond Valuation: Semi-Annual Coupons
For example, suppose you want to value a five-year, $10,000
Government of Canada bond with a 4% coupon, paid twice a
year, given a YTM of 6%.
2
2
2 5
2 5
1 1
2
2
1
2
2
.06
1 1
400 10, 000
2
0.06
2
.06
1
2
2
$9,146.98
n
b
n
b
b
x
x
k
I F
B
k
k
(
| |
+
(
|
\ .
(
= +
(
| |
+
(
|
(
\ .

(
| |
+
(
|
\ .
(
= +
(
| |
+
(
|
\ .

=
Calculator Approach:
10,000 FV
400 2 = PMT
5 x 2 = N
6 2 = I/Y
CPT PV 926.40
There are three factors that affect the price
volatility of a bond
Yield to maturity
Time to maturity
Size of coupon
Yield to maturity
Bond prices go down when the YTM goes up
Bond prices go up when the YTM goes down
Look at the graph on the next slide. It shows
how the price of a 25 year, 10% coupon bond
changes as the bonds YTM varies from 1% to
30%
Note that the graph is not linear instead it is
said to be convex to the origin
Price and Yield: 25 Year Bond, 10% Coupon
Price/Yield Relationship
0
50
100
150
200
250
300
350
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Percent YTM
P
r
i
c
e

p
e
r

$
1
0
0

o
f

F
a
c
e

V
a
l
u
e
The convexity of the price/YTM graph reveals
two important insights:
The price rise due to a fall in YTM is greater than the
price decline due to a rise in YTM, given an identical
change in the YTM
For a given change in YTM, bond prices will change
more when interest rates are low than when they are
high
Bond Convexity
Time to maturity
Long bonds have greater price volatility than
short bonds
The longer the bond, the longer the period for
which the cash flows are fixed
Size of coupon
Low coupon bonds have greater price volatility
than high coupon bonds
High coupons act like a stabilizing device, since a
greater proportion of the bonds total cash flows
occur closer to today & are therefore less affected
by a change in YTM
Interest Rate Risk & Duration
The sensitivity of bond prices to changes in
interest rates is a measure of the bonds
interest rate risk
A bonds interest rate risk is affected by:
Yield to maturity
Term to maturity
Size of coupon
These three factors are all captured in one
number called duration
Duration
Duration is a measure of interest rate risk
The higher the duration, the more sensitive the
bond is to changes in interest rates
A bonds duration will be higher if its:
YTM is lower
Term to maturity is longer
Coupon is lower
Bond Quotations
Issuer Coupon Maturity Price Yield
Canada 5.500 2009-Jun-01 103.79 4.16
Cash Versus Quoted Prices
The quoted price is the price reported by the
media
The cash price is the price paid by an investor
The cash price includes both the quoted price
plus any interest that has accrued since the
last coupon payment date
Cash Versus Quoted Price: Example
Assume you want to purchase a $1,000 bond with a
5% coupon, paid semi-annually. Today is July 15
th
.
The last coupon was paid June 30
th
. If the quoted
price is $902, how much is the cash price?
Solution: The cash price is equal to:
Quoted price of $902
Plus 15 days of interest
( )( )
15
902 1, 000 0.05
365
902 2.05
$904.05
Cash price=Quoted Price+Accrued Interest
| |
= +
|
\ .
= +
=
Bond Yields
Bond Yields
Yield-to-maturity (YTM) the discount rate
used to evaluate bonds
The yield earned by a bond investor who:
Purchases the bond at the current market price
Held the bond to maturity
Reinvested all of the coupons at the YTM
Is the bonds Internal Rate of Return (IRR)
Bond Yield to Maturity

The yield to maturity is that discount rate that causes the
sum of the present value of promised cash flows to equal
the current bond price.

YTM) (
F
YTM
YTM) (
I B
n
n
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-2]
Solving for YTM
To solve for YTM, solve for YTM in the following formula:

Problem: cant solve for YTM algebraically; therefore, must
either use a financial calculator, spreadsheet, trial and error, or
approximation formula.
( )
( )
1 1
1
n
n
YTM
F
B I
YTM
YTM
(
+
= +
(
+
(

Solving for YTM
Example: What is the YTM on a 10 year, 5% coupon
bond (annual pay coupons) that is selling for $980?
( )
( )
( )
( )
10
10
1 1
1
1 1
1, 000
980 50
1
5.26%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM
(
+
= + (
+
(

(
+
= + (
+
(

=
Financial Calculator
1,000 FV
980 +/- PV
50 PMT
10 N
I/Y 5.26%
Solving for YTM: Semi-annual Coupons
When solving for YTM with a semi-annual pay
coupon, the yield obtained must be multiplied
by two to obtain the annual YTM
Example: What is the YTM for a 20 year,
$1,000 bond with a 6% coupon, paid semi-
annually, given a current market price of
$1,030?
Solving for YTM: Semi-annual Coupons
( )
( )
( )
( )
40
40
1 1
1
1 1
1, 000
1, 030 30
1
2.87 2 5.74%
n
n
YTM
F
B I
YTM
YTM
YTM
YTM
YTM
YTM x
(
+
= + (
+
(

(
+
= + (
+
(

= =
1,000 FV
1,030 +/- PV
30 PMT
40 N
I/Y 2.87 x 2
= 5.746%
The Approximation Formula
Where
F = Face Value = Par Value = $1,000
B = Bond Price
I = the semi annual coupon interest
N = number of semi-annual periods left to maturity

1 YTM) annual - semi (1 YTM
YTM annual - semi 2 YTM
2
n
B - F
Maturity to Yield annual - Semi
2
+ =
=
+
+
=
B F
I
Example
Find the yield-to-maturity of a 5 year 6%
coupon bond that is currently priced at $850.
(Always assume the coupon interest is paid
semi-annually.)
Therefore there is coupon interest of $30 paid
semi-annually
There are 10 semi-annual periods left until
maturity
Solution
The actual answer is 9.87%...so of course, the
approximation approach only gives us an approximate
answerbut that is just fine for tests and exams.
% 97 . 9 1 ) 0486 . 1 ( 1 YTM) annual - semi (1 YTM
9.3% 0.09273 2 0.0486 YTM annual - semi 2 YTM
0486 . 0
925 $
30 $ 15 $
2
850 , 1 $
30 $
10
850 $ 000 , 1 $
2
n
B - F
Maturity to Yield annual - Semi
2 2
= = + =
= = = =
=
+
=
+
=
+
+
=
B F
I
The Logic of the Equation
Approximation Formula for YTM
The numerator simply represents the average semi-annual
returns on the investment; it is made up of two
components:
The first component is the average capital gain (if it is a
discount bond) or capital loss (if it is a premium priced bond)
per semi-annual period.
The second component is the semi-annual coupon interest
received.
The denominator represents the average price of the bond.
Therefore the formula is basically, average semi-annual
return on average investment.
Of course, we annualize the semi-annual return so that we
can compare this return to other returns on other
investments for comparison purposes.
Yield to Call
If a bond has a call feature, the issuer can call
the bond prior to its stated maturity
To calculate the yield to call, replace the
maturity date with the first call date
Yield to Call
The yield to call is that discount rate that causes the
present value of all promised cash flows including the call
price (CP) to equal the current bond price.

YTC) (
CP
YTC
YTC) (
I B
n
n
+
+
(
(
(
(
=
1
1 1
1
1
[ 6-3]
Solving for YTC: Semi-Annual Coupons
1,050 FV
1,030 +/- PV
30 PMT
10 N
I/Y 3.081 x 2
= 6.16%
YTC on a 20-year 6 percent bond that is callable in five years at a call price of
$1,050. The bond pays semi-annual coupons and is selling for $1,030.
% 16 . 6 2 % 081 . 3
% 081 . 3
1
050 , 1 $ 1
1
1
30 $ 030 , 1 $
1
1 1
1
1
10
10
= =
=
+
+
(
(
(
(
=
+
+
(
(
(
(
=
YTC
annually semi YTC
YTC) ( YTC
YTC) (

YTC) (
CP
YTC
YTC) (
I B
n
n
Current Yield
The current yield is the yield on the bonds current
market price provided by the annual coupon
It is not a true measure of the return to the bondholder
because it does not consider potential capital gain or
capital losses based on the relationship between the
purchase price of the bond and its par value.

B
interest Annual
CY = [ 6-4]
Current Yield
Example
The current yield is the yield on the bonds current
market price provided by the annual coupon
Example: If a bond has a 5.5% annual pay coupon and
the current market price of the bond is $1,050, the
current yield is:
55
1, 050
5.24%
Annual Coupon
Current Yield =
Current Market Price
=
=
Interest Rate Determinants
Interest Rate Determinants
Interest is the price of money
Basis points 1/100 of 1%
Interest rates go:
Up when the demand for loanable funds rises
Down when the demand for loanable funds falls
Risk-free Interest Rate
Usually use the yield on short federal government
treasury bills as a proxy for the risk-free rate (RF)
The risk-free rate is comprised of two components:
Real rate compensation for deferring consumption
Expected inflation compensation for the expected loss in
purchasing power

(See Figure 6-3 to see rates of inflation and yields on long Canada bonds since 1961)
Inflation and Yields over Time
FIGURE 6-3
Fisher Equation
If we call the risk-free rate the nominal rate, then the
relationship between the real rate, the nominal rate and
expected inflation is usually referred to as the Fisher
Equation (after Irving Fisher)
inflation Expected rate Real RF + = [ 6-5]
Fisher Equation
When inflation is low, can safely use the approximation
formula:

When inflation is high, use the exact form of the Fisher
Equation:
Nominal Real
R = R +Expected Inflation
( ) ( )( )
1 1 1
Nominal Real
R = R Expected Inflation + + +
Fisher Equation
Example
If the real rate is 3% and the nominal rate is 5.5%, what is the
approximate expected future inflation rate?
5.5 3
2.5%
Nominal Real
R = R +Expected Inflation
Expected Inflation
Expected Inflation
= +
=
Global Influences on Interest Rates
Canadian domestic interest rates are heavily
influenced by global interest rates
Interest rate parity (IRP) theory states that FX
forward rates will be established that equalize
the yield an investor can earn, whether
investing domestically or in a foreign
jurisdiction
A country with high inflation and high interest rates
will have a depreciating currency
Term Structure of Interest Rates
Is that set of rates (YTM) for a given risk-class
of debt securities (for example, Government of
Canada Bonds) at a given point in time.
When plotted on a graph, the line is called a
Yield Curve

The Yield Curve is the graph created by putting
term to maturity on the X axis, YTM on the Y
axis and then plotting the yield at each
maturity.
The four typical shapes of yield curves:
Upward sloping (the most common shape)
Downward sloping
Flat
Humped

(See Figure 6-4 for Yield curves that existed at various times in Canada)
Historical Yield Curves
1990, 1994, 1998, 2004
P
e
r
c
e
n
t

Term Left to Maturity
16

14

12

10

8

6

4

2

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
FIGURE 6-4
1990 1994 1998 2004
Theories of the Term Structure
Three theories are used to explain the shape of
the term structure
Liquidity preference theory
Investors must be paid a liquidity premium to hold
less liquid, long-term debt
Expectations theory
The long rate is the average of expected future short
interest rates
Market segmentation theory
Distinct markets exist for securities of different
maturities
Risk Premiums

More risky bonds (i.e.. BBB rated Corporate Bonds) will
have their own yield curve and it will plot at higher YTM at
every term to maturity because of the default risk that BBBs
carry
The difference between the YTM on a 10-year BBB
corporate bond and a 10-year Government of Canada bond
is called a yield spread and represents a default-risk
premium investors demand for investing in more risky
securities.
Spreads will increase when pessimism increases in the
economy
Spreads will narrow during times of economic expansion
(confidence)
Yield Curves for Different Risk
Classes
Risk Premiums (Yield Spreads)
P
e
r
c
e
n
t

Term Left to Maturity
16

14

12

10

8

6

4

2

0
1 mth 3 mths 6 mths 1 yr 2yrs 5 yrs 7 yrs 10 yrs 30 yrs
BBB Corporates Government of Canada Bonds
Yield
Spread
Risk Premiums
The YTM on a corporate bond is comprised of:

The maturity yield differential is explained by the term
structure
Spread is the additional yield due to default risk
Spread al differenti yield Maturity - / RF k
b
+ + = =YTM [ 6-6]
Debt Ratings
All publicly traded bonds are assigned a risk
rating by a rating agency, such as Dominion
Bond Rating Service (DBRS), Standard &
Poors (S&P), Moodys, Fitch, etc.
Bonds are categorized as
Investment grade top four rating categories (AAA,
AA, A & BBB)
Junk or high yield everything below investment
grade (BB, B, CCC, CC, D, Suspended)

Why Do Bonds Have Different
Yields?
Default risk the higher the default risk, the
higher the required YTM
Liquidity the less liquid the bond, the higher
the required YTM
Call features increase required YTM
Extendible feature reduce required YTM
Retractable feature reduce required YTM

Other Types of Bonds/Debt Instruments
Treasury Bills
Treasury bills are short-term obligations of government
with an initial term to maturity of one year or less
Issued at a discount and mature at face value
The difference between the issue price and the face
value is treated as interest income
To calculate the price of a T-bill, use the following
formula
1
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
Where:
P = market price of the T Bill
F = face value of the T Bill
BEY = the bond equivalent yield
n = the number of days until maturity
B = the annual basis (365 days in Canada)
Treasury Bills: Example
What is the price of a $1,000,000 Canadian T bill with
80 days to maturity and a BEY of 4.5%?
1
1, 000, 000
80
1 .045
365
$990, 233.32
T Bill
F
P
n
BEY
B
=
| |
+
|
\ .
=
| |
+
|
\ .
=
Solving for Yield on a T Bill
To solve for the yield on a T bill, rearrange the previous
formula and solve for BEY.
Example: What is the yield on a $100,000 T bill with 180
days to maturity and a market price of $98,200?
100, 000 98, 200 365
98, 200 180
3.72%
F P B
BEY
P n
| |
=
|
\ .
| |
=
|
\ .
=
Zero Coupon Bonds
A zero coupon bond is a bond issued at a
discount that matures at par or face value
A zero coupon bond has no reinvestment rate
risk, since there are no coupons to be
reinvested
To calculate the price of a zero coupon bond,
solve for the PV of the face amount
Zero Coupon Bonds
Example: What is the market price of a $50,000 zero
coupon bond with 25 years to maturity that is
currently yielding 6%?

( )
( )
25
F
1
50, 000
1.06
$11, 649.93
n
b
B
k
=
+
=
=
Floating Rate & Real Return Bonds
Floating rate bonds have a coupon that floats
with some reference rate, such as the yield on
T bills
Because the coupon floats, the market price will
typically be close to the bonds face value
Real return bonds are issued by the
Government of Canada to protect investors
against unexpected inflation
Each period, the face value of the bond is grossed
up by the inflation rate. The coupon is then paid on
the grossed up face value.
Canada Savings Bonds
A Canada Savings Bond (CSB) is a special
type of bond issued by the Government of
Canada
It is issued in two forms:
Regular interest interest is paid annually
Compound interest interest compounds over the
life of the bond
CSBs are redeemable at any chartered bank in
Canada at their face value
There is no secondary market for CSBs
Summary and Conclusions
In this chapter you have learned:
About the nature of bonds as an investment
How to value a bond using discounted cash flow
concepts
About the determinants of interest rates and
theories used to explain the term structure of
interest rates
Interesting Web Links
1. Bond Characteristics
2. Bond Valuation
3. Bond Yields
4. Bond Ratings and Agencies
End of Chapter Problems
Chapter 6 Bond Valuation and Interest
Rates
Question 6 - 1
Which of the following statements concerning bonds is
incorrect?
A. They involve blended payments of principal and interest.
B. They have a fixed maturity date at which time the issuer
repays the full principal amount.
C. Bondholders are paid a series of fixed periodic amounts
before the maturity date.
D. The bond indenture is a legal document, specifying
payment requirements and so on.
Solution: A

Mortgages have blended payments including interest and
principal payment, not bonds.
End-of-Chapter Problems
Question 6 - 2
Which of the following statements is incorrect?
A. Callable bonds give the bond issuer an option to call the
bond at a predetermined price.
B. All debentures are secured bonds.
C. Extendible bonds allow bondholders to extend the
maturity date.
D. Convertible bonds give the bondholders an option to
convert into common shares at a predetermined
conversion ratio.

Solution: B

Debentures are generally unsecured.
Question 6 - 3
Determine the price of a five-year 7 percent annual coupon bond
when the market rate is 8 percent. The face value is $100.
A. $100
B. $102.50
C. $96.01
D. $104.10

Solution: C

Or, by financial calculator:
N = 5; I/Y= 8; PMT = 7; FV = 100; CPT PV = 96.01
$96.01 68.0583 27.9490
) 08 . 1 (
1
100
08 .
) 08 . 1 (
1
1
7
5
5
= + =
+
+
(
(
(
(
= B
Question 6 - 4
Which of the following bond prices is most sensitive to
market rate changes? The par value = $100 for all.
A. 5-year, 5 percent coupon rate, yield = 5.5 percent
B. 3-year, 8 percent coupon rate, yield = 5.6 percent
C. 7.5-year, 4.5 percent coupon rate, yield = 5.5 percent
D. 10-year, 4.5 percent coupon rate, yield = 5.5 percent

Solution: D
All else being equal, interest rate risk is positively related to term to
maturity, but negatively related to coupon rate and market yields.
The bond in choice D has the lowest yield, lowest coupon rate and
the longest term to maturity relative to other bonds. Therefore it has
the highest interest rate risk.
Question 6 - 5
Determine the yield to maturity on a six-year, 7 percent,
semi-annual-pay bond, which is now priced at $993. Use a
financial calculator.
A. 7.05 percent
B. 6.98 percent
C. 3.57 percent
D. 7.15 percent

Solution: D
Coupon = ($1,000)(7%)/2=$35, N=62=12, FV=1,000, PV= 993

Using a financial calculator,
N=12, PV= 993, PMT=35, FV=1,000 CPT I/Y=3.5727
Therefore, YTM=3.5727%2=7.15%
Question 6 - 6
Which of the following statements is correct?
A. Current yield is the ratio of annual coupon payment divided by
the par value.
B. When the coupon rate is higher than the market rate, the bond is
priced at discount.
C. When the market rate is higher than the coupon rate, the bond is
priced at premium.
D. If a bond is at discount, the coupon rate < current yield < YTM.

Solution: D
Current yield is the ratio of annual coupon divided by the current
market price. When coupon rate is higher than the market rate, bond
is at premium and when the market rate is higher, bond is at discount.
Question 6 - 7
According to interest rate parity (IRP) theory,
A. differences in interest rates across countries cannot be totally offset by
expected changes in exchange rates.
B. forward exchange rates may be locked in today to eliminate foreign
exchange risk and ensure investors can profit from moving capital to
countries with higher interest rates.
C. the inflation differentials between countries affect both interest rates and
currency exchange rates.
D. the country with a higher inflation rate will see its currency appreciate
against another country with a lower inflation rate.

Solution: C
Difference in interest rates across countries can be offset by expected changes in
exchange rates. If a country has a higher expected inflation rate, its currency
will depreciate.

IRP states that forward exchange rates locked-in today to eliminate foreign
exchange risk ensure investors earn the same amount no matter where they
invest.
Question 6 - 8
Which statement is incorrect?
A. The liquidity preference theory states that investors prefer
short-term debt.
B. According to the expectations theory, a downward-sloping yield
curve implies that interest rates are expected to decline in the
future.
C. The risk premium in the bond yield reflects default risk, liquidity
risk, and issue-specific features.
D. A debt rating of AAA is a worse rating than BB for S&P.

Solution: D
AAA is rated higher than BB.
Question 6 - 9
Calculate the quoted price of a 182-day Canadian T-bill
that has a face value of $10,000 and a quoted yield of
5.5 percent.
A. $9,733.07
B. $9,478.67
C. $97.3307
D. $94.7867

Solution: C

Because it is quoted on a basis of $100, therefore quoted price is
$97.3307.
07 . 733 , 9 $
02742466 . 1
000 , 10
)
365
182
055 . 0 1 (
000 , 10
= =
+
= P
Question 6 - 10
Which of the following statements is false?
A. Zero coupon bonds are deep-discount bonds.
B. Zero coupon bonds are often created when cash flows are
stripped from traditional bonds.
C. Floating rate bonds provide protection against decreasing
interest rates.
D. There are two forms of return available for Canadian Savings
Bond buyers.

Solution: C

Floating rate bonds provide protection against increasing interest
rates compared to fixed rate bonds.
Question 6 - 11
State the relationship between the market rates and bond
prices.

Solution:

When market interest rates increase, prices of bonds decrease.
When market interest rates decrease, prices of bonds increase.
Question 6 - 12
Find the price of a bond with FV = $1,000, a coupon rate
of 6 percent (paid semi-annually), and three years to
maturity when
A. kb = 7 percent.
B. kb = 6 percent.
C. kb = 5 percent.

Solution:

Using a financial calculator:
A. N = 6; I/Y= 3.5; PMT = 30; FV = 1,000; CPT PV = 973.36
B. N = 6; I/Y= 3; PMT = 30; FV = 1,000; CPT PV = 1,000
C. N = 6; I/Y= 2.5; PMT = 30; FV = 1,000; CPT PV = 1,027.54
Clearly, the price of bonds is inversely related to the market yield.
Question 6 - 13
At maturity, each of the following zero-coupon bonds (pure
discount bonds) will be worth $1,000. For each bond, find
the missing quantity in the table below.

Solution:

Using a financial calculator:
A. N = 30; PMT = 0; FV = 1,000; PV = - 400; CPT I/Y = 3.10%
B. I/Y = 8; PMT = 0; FV = 1,000; PV = - 400; CPT N = 11.9 years
C. N = 10; I/Y = 12; PMT = 0; FV = 1,000; CPT PV = $321.97
Price Maturity
(years)
Yield to
Maturity
A.
$400 30
B.
$400 8%
C.
10 12%
Question 6 - 14
Suppose that a government of Canada 9 percent annual-
pay bond that matures in two years has a yield to maturity
of 9.80 percent. If inflation is expected to be 3 percent per
year over the next two years, what coupon rate would you
expect to find on a Real Return Bond that is otherwise
identical?

Solution:

Using the approximate relationship:
9.80% = Real Rate + 3%, so the Real Rate = 6.8%.

Using the exact relationship:
Real Rate = (1+0.098)/(1+0.03) 1 = 6.60%
Question 6 - 15
Suppose the inflation rate in Canada, as measured by the CPI,
has been averaging 2.5 percent in recent years. The most recent
Bank of Canada announcement indicates that it expects
4 percent inflation over the next year. If the real rate of return on
Canadian T-bills is 1.75 percent, what is the nominal risk-free
rate?

Solution:

The Fisher relationship uses expected inflation figures, not the actual rate of
inflation experienced in the past. Therefore:

RF = 1.75% + 4% = 5.75%

Using the exact relationship:

RF = (1+0.0175)(1.04)1=5.82%
Question 6 - 16
The following values are the spread for corporate bond yields:

A. One-year T-bills are trading with a YTM of 6 percent. What yield would you
expect to find on A rated corporate bonds maturing in one year?
B. Five-year government bonds have a maturity yield differential of 50 basis
points. What yield would you expect to observe on non-investment grade (BB
rated) corporate bonds with a five-year maturity?

Solution:
A. We can assume that T-bills (short-term, federal government bonds) have the highest possible credit rating,
AAA, because they have virtually no default risk. We expect lower rated (riskier) bonds to have a higher yield.
For A rated bonds, we should expect kb = 6% + 0.45% = 6.45%
B. Adding the maturity yield and the spread for this bond rating, we find: kb = 6% + 0.50% + 1.10% = 7.60%

Bond Rating Spread over AAA
AA 30 basis points
A 45 basis points
BBB 70 basis points
BB 110 basis points
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