Q.1. Does an investor who purchases a zero-coupon bond face reinvestment risk?

A zero-coupon bond is a bond that pays no interest and trades at a discount

to its face value. It is also called a pure discount bond or deep discount bond.
U.S. Treasury bills are an example of a zero-coupon bond.

Reinvestment risk is the risk that an investor will be unable to reinvest a bond’s
cash flows (coupon payments) at a rate equal to the investment’s required rate
of return. Zero-coupon bonds are the only type of fixed-income investments
that are not subject to investment risk – they do not involve periodic coupon
payments.

Q.2. How do market participants gauge the default risk of a bond issue?

Credit risk is measured by the default rating or credit rating assigned to a bond issue by one of the
three rating companies—Standard & Poor’s, Moody’s, and Fitch.

Often market participants will engage in credit analysis. Market participants analyze an issuer to assess
future cash flows generated by the borrower available to pay debt. For corporations this is EBITDA. For
government and municipal borrowers, this is tax revenue or revenue from activates the bond has
financed. Credit analysis is performed “in-house” by most large bond purchasers

Q.3. Suppose that you are reviewing a price sheet for bonds and see the following prices (per
$100 par value) reported. You observe what seem to be several errors. Without calculating
the price of each bond, indicate which bonds seem to be reported incorrectly, and explain
why.
Bond Price Coupon Rate (%) Required Yield (%)
U 90 6 9
V 96 9 8
W 110 8 6
X 105 0 5
Y 107 7 9
Z 100 6 6

If the required yield is the same as the coupon rate then the price of the bond should sell at its par
value. This appears to be the case of bond Z. If the required yield decreases below the coupon rate
then the price of a bond should increase. This is the case for bond W. This is not the case for bond V so
this bond is not reported correctly. If the required yield increases above the coupon rate then the price of
a bond should decrease. This is the case for bond U. This is not the case for bonds X and Y so these
bonds are not reported correctly. Thus, bonds V, X, and Y are incorrectly reported because the change
in the bond price isnot consistent with the difference between the coupon rate and the required yield.

Q.4. Suppose that you purchased a debt obligation three years ago at its par value of $100,000
and nine years remaining to maturity. The market price of this debt obligation today is
$90,000. What are some reasons why the price of this debt obligation could have declined
from time you purchased it three years ago?

The price of a bond will chan e for one or more of the followin three reasons:(i) There is a chan e in
the required yield owin to chan es in the credit quality of the issuer.(ii) There is a chan e in the price
of the bond sellin at a premium or a discount, without anychan e in the required yield, simply because
the bond is movin toward maturity.1'

(iii) There is a chan e in the required yield owin to a chan e in the yield on comparable bonds(i.e., a
chan e in the yield required by the marBet).The first and third reasons are the liBely reasons for the
situation where the bond has plummetedfrom "1##,### to "*#,###. The bond has plummeted in value
because the credit quality of theissuer has fallen and>or the bond has plummeted because the yield on
comparable bonds hasincreased.

Q.5. If the discount rate that is used to calculate the present value of a debt obligation’s cash
flow is increased, what happens to the price of that debt obligation?

Q.6. A portfolio manager is considering buying two bonds. Bond A matures in three years
and has a coupon rate of 10% payable semiannually. Bond B, of the same credit quality,
matures in 10 years and has a coupon rate of 12% payable semiannually. Both bonds are
priced at par.
(a) Suppose that the portfolio manager plans to hold the bond that is purchased for three
years. Which would be the best bond for the portfolio manager to purchase?

(b) Suppose that the discount rate used to calculate the present value of a debt obligation’s
cash flow is x%. Suppose also that the only cash flows for this debt obligation are $200,000
four years from now and $200,000 five years from now. For which of these cash flows will
the present value be greater?

Q.7. You are a portfolio manager who has presented a report to a client. The report indicates
the duration of each security in the portfolio. One of the securities has a maturity of 15 years
but a duration of 25. The client believes that there is an error in the report because he believes
that the duration cannot be greater than the security’s maturity. What would be your
response to this client?

Q.8. “Forward rates are poor predictors of the actual future rates that are realized.
Consequently, they are of little value to an investor.” Explain why you agree or disagree with
this statement.