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Topic6 Interest Rates and Bond Valuation
Topic6 Interest Rates and Bond Valuation
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That still leaves a lot of interest rates to check. One way to get a starting point is to use the following equation,
which will give you an approximation of the YTM:
Approximate YTM = [Annual interest payment + (Par value Price) / Years to maturity] /
[(Price + Par value) / 2]
Solving for this problem, we get:
Approximate YTM = [$100 + ($145.70 / 9)] / [($1,145.70 + 1,000) / 2]
Approximate YTM = .0781 or 7.81%
This is not the exact YTM, but it is close, and it will give you a place to start.
Q5.
Coupon Rates. Merton Enterprises has bonds on the market making annual payments, with 16 years to
maturity, and selling for $963. At this price, the bonds yield 7.5 percent. What must the coupon rate be on Merton's
bonds?
Here we need to find the coupon rate of the bond. All we need to do is to set up the bond pricing equation and
solve for the coupon payment as follows:
P = $963 = C(PVIFA7.5%,16) + $1,000(PVIF7.5%,16)
Solving for the coupon payment, we get:
C = $70.95
The coupon payment is the coupon rate times par value. Using this relationship, we get:
Coupon rate = $70.95 / $1,000
Coupon rate = .0710 or 7.10%
Q11. Nominal and Real Returns. An investment offers a 13 percent total return over the coming year. Bill
Bernanke thinks the total real return on this investment will be only 6 percent. What does Bill believe the inflation
rate will be over the next year?
The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and
inflation, is:
(1 + R) = (1 + r)(1 + h)
h = [(1 + .13) / (1 + .06)] 1
h = .066 or 6.60%
Q12. Nominal versus Real Returns. Say you own an asset that had a total return last year of 17 percent. If the
inflation rate last year was 2.9 percent, what was your real return?
The Fisher equation, which shows the exact relationship between nominal interest rates, real interest rates, and
inflation, is:
(1 + R) = (1 + r)(1 + h)
r = [(1 + .17) / (1.029)] 1
r = .137 or 13.70%
Q18. Bond Yields. PK Software has 7.5 percent coupon bonds on the market with 22 years to maturity. The
bonds make semi-annual payments and currently sell for 106 percent of par. What is the current yield on PK's
bonds? The YTM? The effective annual yield?
The current yield is:
Current yield = Annual coupon payment / Price
Current yield = $75 / $1,060
Current yield = 0.0708 or 7.08%
The bond price equation for this bond is:
P0 = $1,060 = $37.50(PVIFAR%,44) + $1,000(PVIFR%,44)
Using a spreadsheet, financial calculator, or trial and error we find:
R = 3.482%
This is the semiannual interest rate, so the YTM is:
YTM = 2 3.482%
YTM = 6.96%
The effective annual yield is the same as the EAR, so using the EAR equation from the previous chapter:
Effective annual yield = (1 + 0.03482)2 1
Effective annual yield = .0708 or 7.08%