A B C D E F G

20 INPUTS:
21 Years to maturity = N = 15
22 Coupon payment = INT = $100
23 Par value = M = $1,000
24 Required return = rd = 10%
25
26 1. Step-by-Step: Divide each cash flow by (1 + r d)t

27 Coupon PV of Coupon PV of
Year (t) Payment Payment Par Value Par Value
28 1 $100 $90.91
29 2 $100 $82.64
30 3 $100 $75.13
31 4 $100 $68.30
32 5 $100 $62.09
33 6 $100 $56.45
34 7 $100 $51.32
35 8 $100 $46.65
36 9 $100 $42.41
37 10 $100 $38.55
38 11 $100 $35.05
39 12 $100 $31.86
40 13 $100 $28.97
41 14 $100 $26.33
42 15 $100 $23.94 $1,000 $239.39
43 Total = $760.61
44
45 VB = PV of all coupon payments + PV of par value = $1,000.00
46
47 Inputs: 15 0 100 1000
48 2. Financial Calculator: N I/YR PV PMT FV
49 Output: −$1,000.00
50
51 3. Excel: PV function: PVN = =PV(Rate,Nper,Pmt,Fv,Type)
52 Fixed inputs: PVN = =PV(10%,15,100,1000) −$1,000.00
53 Cell references: PVN = =PV(C24,C21,C22,C23) −$1,000.00
 A B C D E F G
1 Tool Kit Web 5A
2 OID and Premium Bonds
3
4
5
6 Vandenburg Corporation needs to issue $50 million to finance a project, and it has decided to raise the funds by
7 issuing $1,000 par value, zero coupon bonds. The going interest rate on such debt is 6%, and the combined
federal-plus-state tax rate is 25%. Find the issue price of Vandenburg's bonds, construct a table to analyze the
8 cash flows attributable to one of the bonds, and determine the after-tax cost of debt for the issue. Then, indicate
9 the total par value of the issue.
10
11 This example analyzes the after-tax cost of issuing zero coupon debt.
12
13
14 Figure 5A-1
15 Analysis of a Zero Coupon Bond from Issuer’s Perspective
16 Input Data
17 Amount needed = $50,000,000
18 Maturity value= $1,000
19 Pre-tax market interest rate, rd = 6%
20 Maturity (in years) = 5
21 Corporate tax rate = 25%
22 Coupon rate = 0%
23 Coupon payment (assuming annual payments) = $0
24
25 Analysis:
26
27 Issue Price =PV of payments at rd = $747.26
28
29 Years 0 1 2 3 4
30 (1) Remaining years 5 4 3 2 1
31 (2) Year-end accrued valu $747.26 $792.09 $839.62 $890.00 $943.40
32 (3) Interest payment $0.00 $0.00 $0.00 $0.00
33 (4) Implied interest
34 deduction on discount $44.84 $47.53 $50.38 $53.40
35 (5) Tax savings $11.21 $11.88 $12.59 $13.35
36 (6) Cash flow $747.26 $11.21 $11.88 $12.59 $13.35
37
38 After-tax cost of debt = 4.50%
39
40 Number of $1,000 zeros the
41 company must issue to raise $50 million = (Amount needed)/(Price per bond)
42 = 66,911.279 bonds
43 Face amount of bonds = # bonds x $1,000 = $66,911,279
44
45
46
47
48 Figure 5A-2
49 Analysis of an OID Bond from Issuer’s Perspective
50 Input Data
 A B C D E F G
51 Amount needed = $50,000,000
52 Maturity value= $1,000
53 Pre-tax market interest rate, rd = 6%
54 Maturity (in years) = 5
55 Corporate tax rate = 25%
56 Coupon rate = 5%
57 Coupon payment (assuming annual payments) = $50
58
59 Analysis:
60
61 Issue Price =PV of payments at rd = $957.88
62
63 Years 0 1 2 3 4
64 (1) Remaining years 5 4 3 2 1
65 (2) Year-end accrued valu $957.88 $965.35 $973.27 $981.67 $990.57
66 (3) Interest payment $50.00 $50.00 $50.00 $50.00
67 (4) Implied interest
68 deduction on discount $7.47 $7.92 $8.40 $8.90
69 (5) Tax savings $14.37 $14.48 $14.60 $14.72
70 (6) Cash flow $957.88 −$35.63 −$35.52 −$35.40 −$35.28
71
72 After-tax cost of debt = 4.50%
73
74 Number of $1,000 OID bonds the
75 company must issue to raise $50 million = (Amount needed)/(Price per bond)
76 = 52,198.803 bonds
77 Face amount of bonds = # bonds x $1,000 = $52,198,803
78
79
80 Figure 5A-3
81 Analysis of a de minimis OID Bond from Issuer’s Perspective
82 Input Data
83 Amount needed = $50,000,000
84 Maturity value= $1,000
85 Pre-tax market interest rate, rd = 6%
86 Maturity (in years) = 30
87 Corporate tax rate = 25%
88 Coupon rate = 5.5%
89 Coupon payment (assuming annual payments) = $55.0
90 De minimis amount = Maturity x 1000 x 0.25% = $75.00
91
92 Analysis:
93
94 Issue Price =PV of payments at rd = $931.18
95 Discount = $68.82
96 Is discount less than de minimis? Yes--use linear amortization
97 Linear amortization = $2.29
98
99 Years 0 1 2 3 4
100 (1) Remaining years 30 29 28 27 26
 A B C D E F G
101 (2) Discount amortization $2.29 $2.29 $2.29 $2.29
102 (3) Year-end accrued valu $931.18 $933.47 $935.76 $938.06 $940.35
103 (4) Interest payment $55.00 $55.00 $55.00 $55.00
104 (5) Implied interest
105 deduction on discount $2.29 $2.29 $2.29 $2.29
106 (6) Tax savings $14.32 $14.32 $14.32 $14.32
107 (7) Cash flow $931.18 −$40.68 −$40.68 −$40.68 −$40.68
108
109 After-tax cost of debt = 4.4897%
110
111
112
113 Figure 5A-4
114 Analysis of a Premium Bond from Issuer’s Perspective
115 Input Data
116 Amount needed = $50,000,000
117 Maturity value= $1,000
118 Pre-tax market interest rate, rd = 6%
119 Maturity (in years) = 5
120 Corporate tax rate = 25%
121 Coupon rate = 8%
122 Coupon payment (assuming annual payments) = $80
123
124 Analysis:
125
126 Issue Price =PV of payments at rd = $1,084.25
127
128 Years 0 1 2 3 4
129 (1) Remaining years 5 4 3 2 1
130 (2) Year-end accrued valu $1,084.25 $1,069.30 $1,053.46 $1,036.67 $1,018.87
131 (3) Interest payment $80.00 $80.00 $80.00 $80.00
132 (4) Implied reduction in
133 interest due to premium −$14.95 −$15.84 −$16.79 −$17.80
134 (5) Tax savings $16.26 $16.04 $15.80 $15.55
135 (6) Cash flow $1,084.25 −$63.74 −$63.96 −$64.20 −$64.45
136
137 After-tax cost of debt = 4.500%
138
139 Number of $1,000 Premium bonds the
140 company must issue to raise $50 million = (Amount needed)/(Price per bond)
141 = 46,114.942 bonds
142 Face amount of bonds = # bonds x $1,000 = $46,114,942
143
144
145
146
147
148
149 Figure 5A-5
150 Comparison of Total Bond Issue After-Tax Cash Flows: OID, Par, and Premium Bond
 A B C D E F G
151
152 Total bond issue after-tax cash flows
153 Bond Type 0 1 2 3 4 5
154 OID $50,000,000 −$1,859,940 −$1,854,089 −$1,847,887 −$1,841,313 −$54,033,148
155 Par $50,000,000 −$2,250,000 −$2,250,000 −$2,250,000 −$2,250,000 −$52,250,000
156 Premium $50,000,000 −$2,939,195 −$2,949,533 −$2,960,491 −$2,972,107 −$49,099,362
 H I J K L M N O
1 ###
2
3
4
5
6 the funds by
t, and it has decided to raise
n such debt is 6%, and the 7 combined
s bonds, construct a table to analyze the
8 Then, indicate
x cost of debt for the issue.
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29 5
30 0
31 ###
32 $0.00
33
34 $56.60
35 $14.15
36 −$985.85
37
38
39
40
41
42
43
44
45
46
47
48
49
50
 H I J K L M N O
51
52
53
54
55
56
57
58
59
60
61
62
63 5
64 0
65 ###
66 $50.00
67
68 $9.43
69 $14.86
70 −$1,035.14
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99 5 6 7 8 9 10 11 12
100 25 24 23 22 21 20 19 18
 H I J K L M N O
101 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29
102 $942.65 $944.94 $947.23 $949.53 $951.82 $954.12 $956.41 $958.71
103 $55.00 $55.00 $55.00 $55.00 $55.00 $55.00 $55.00 $55.00
104
105 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29
106 $14.32 $14.32 $14.32 $14.32 $14.32 $14.32 $14.32 $14.32
107 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128 5
129 0
130 $1,000.00
131 $80.00
132
133 −$18.87
134 $15.28
135 −$1,064.72
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
 H I J K L M N O
151
152 After-tax
153 cost of debt
154 4.50%
155 4.50%
156 4.50%
 P Q R S T U V
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99 13 14 15 16 17 18 19
100 17 16 15 14 13 12 11
 P Q R S T U V
101 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29
102 $961.00 $963.29 $965.59 $967.88 $970.18 $972.47 $974.76
103 $55.00 $55.00 $55.00 $55.00 $55.00 $55.00 $55.00
104
105 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29
106 $14.32 $14.32 $14.32 $14.32 $14.32 $14.32 $14.32
107 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
 W X Y Z AA AB AC
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99 20 21 22 23 24 25 26
100 10 9 8 7 6 5 4
 W X Y Z AA AB AC
101 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29
102 $977.06 $979.35 $981.65 $983.94 $986.24 $988.53 $990.82
103 $55.00 $55.00 $55.00 $55.00 $55.00 $55.00 $55.00
104
105 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29 $2.29
106 $14.32 $14.32 $14.32 $14.32 $14.32 $14.32 $14.32
107 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68 −$40.68
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
 AD AE AF AG
51
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54
55
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57
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63
64
65
66
67
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69
70
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72
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89
90
91
92
93
94
95
96
97
98
99 27 28 29 30
100 3 2 1 0
 AD AE AF AG
101 $2.29 $2.29 $2.29 $2.29
102 $993.12 $995.41 $997.71 $1,000.00
103 $55.00 $55.00 $55.00 $55.00
104
105 $2.29 $2.29 $2.29 $2.29
106 $14.32 $14.32 $14.32 $14.32
107 −$40.68 −$40.68 −$40.68 −$1,040.68
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
146
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148
149
150
 A B C D E F
1 Tool Kit Web 5C
2
3 Duration
4
5 Duration is a measure of risk for bonds. The following example illustrates its calculation.
6
7 Figure 5C-1
8 Duration
9 Inputs
10 Years to maturity = 20
11 Coupon rate = 9.00%
12 Annual payment = $90.0
13 Par value = FV = $1,000
14 Going rate, r = 9.00%
15 Analysis:

16 t CFt PV of CFt t x (PV of CFt)

(1) (2) (3) (4)
17 1 $90 $82.57 82.57
18 2 $90 $75.75 151.50
19 3 $90 $69.50 208.49
20 4 $90 $63.76 255.03
21 5 $90 $58.49 292.47
22 6 $90 $53.66 321.98
23 7 $90 $49.23 344.63
24 8 $90 $45.17 361.34
25 9 $90 $41.44 372.95
26 10 $90 $38.02 380.17
27 11 $90 $34.88 383.66
28 12 $90 $32.00 383.98
29 13 $90 $29.36 381.63
30 14 $90 $26.93 377.05
31 15 $90 $24.71 370.63
32 16 $90 $22.67 362.69
33 17 $90 $20.80 353.54
34 18 $90 $19.08 343.43
35 19 $90 $17.50 332.58
36 20 $1,090 $194.49 3,889.79
37 ↓ ↓

38 Sum of
VB = $1,000.00 (t x PV of CFt ) = $9,950.11
39
40 Duration = [Sum of (t x PV of CFt)] / VB = 9.95
41
42
43 Finding Duration with the Excel Formula
44
45 Settlement date = 1/1/2021
 A B C D E F
46 Maturity 12/31/2040
47 Coupon = 9%
48 Yield = 9%
49 Frequency = 1
50
51 Duration = 9.95
52
53
54
Consider the amount that would accumulate during the first 10 years, if all coupons are reinvested at the original
55 interest rate of 9%. To do this, first find the amount that would be in the account at 10 years (including the 10-
56 year coupon). Then we find the value of the bond at year 10 based on the payments from 11 and on.
57
58 Duration of Bond = 9.95011
59 Target value
60 at year 10 = $10,000.00
61 FV of reinvested coupons at year 10 if no change in rates = $1,367.36
62 PV at year 10 of remaining payments if no change in rates = $1,000.00
63 Total value at year 10 if no change in rates = $2,367.36
64 Value of bonds to be purchased to provide target at 10 years = $4,224.11
65 Number of bonds purchased = 4.22
66
67
68 Now find the value at year 10 if the market interest rate (shown below) changes immediately after time zero, based
69 on the total number of bonds that were purchased.
70
71 Interest rate = 9.00%
72
73
74 FV at year 10 = $5,775.89
75 PV of payments beyond year 10 discounted back to year 10 = $4,224.11
76 The total value of the position at time 9.95011 is the value of the reinvested coupon and the current value of the
77 bond.
78
79 Value of reinvested coupons: $5,775.89
80 Current value of bond: $4,224.11
81 Total value of position = $10,000.00
82
83
84
85
86 As the table below shows, the total value of a position at a future time equal to the orginal duration will not fall if
interest rates change. For example, if rates go up, the value of reinvested coupons increases and the value of the
bond at the future date (t=duration) falls, but the net affect is an increase in total value. If rates go down, the value
87 of reinvested coupons goes down, but the future value of the bond goes up, for a net increase in value. Thus, if the
desired time horizon is equal to the bond's duration, the value of the position will not fall if interest rates change.
88
 A B C D E F

89
Change in Total
Reinvested Current Price Value from
Coupons at t=Duration Total Value Original Target
90 $5,775.89 $4,224.11 $10,000.00
91 1% $11,402.15 $1,402.15
92 2% $11,042.90 $1,042.90
93 3% $10,744.28 $744.28
94 4% $10,501.53 $501.53
95 5% $10,310.54 $310.54
96 6% $10,167.74 $167.74
97 7% $10,070.07 $70.07
98 8% $10,014.90 $14.90
99 9% $10,000.00 $0.00
100 10% $10,023.48 $23.48
101 11% $10,083.77 $83.77
102 12% $10,179.59 $179.59
103 13% $10,309.90 $309.90
104 14% $10,473.89 $473.89
105 15% $10,670.98 $670.98
106 16% $10,900.76 $900.76
107
108
109 Using Duration to Measure Risk
110
111 If the term structure is flat and the change in r is fairly small, then the change in the bond’s price (∆V B
112
113 ∆VB = (−Duration)(Percentage change in 1 + r)(V B)
114
115 Suppose r changes to 9.10%
116
117 −Duration before change in r = -9.95
118 Percentage change in 1 + r = 0.0917%
119 ∆VB before change in r= $1,000.00
120 Predicted change in VB = -$9.13
121
122 Actual VB after change in r= $990.94
123 Actual change in VB after change in r= -$9.06
 G
1 11/20/2018
2
3
4
es its calculation. 5
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15

16

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38

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 G
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47
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49
50
51
52
53
54
all coupons are reinvested at the original
55
account at 10 years (including the 10-
payments from 11 and56 on.
57
58
59
60
61
62
63
64
65
66
67
68 time zero, based
hanges immediately after
69
70
71
72
73
74
75
76
ed coupon and the current value of the
77
78
79
80
81
82
83
84
85
86 will not fall if
ual to the orginal duration
coupons increases and the value of the
in total value. If rates go down, the value
p, for a net increase in 87value. Thus, if the
ition will not fall if interest rates change.
88
 G

89

90
91
92
93
94
95
96
97
98
99
100
101
102
103
104
105
106
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111
ange in the bond’s price (∆V B) is:
112
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123
Tool Kit Web 5D 11/20/2018

The Pure Expectations Theory and Estimation of Forward Rates

The shape of the yield curve depends primarily on two key factors: (1) expectations about future inflation and (2)
perceptions about the relative riskiness of securities of different maturities. The first factor is the basis for the Pure
Expectations Hypothesis. If the relationship between expectations for future inflation and bond yields is controlling, i. e., if
no maturity premiums existed, then the pure expectations theory posits that forward interest rates can be predicted by
"backing them out of the yield curve." Essentially, under the pure expectations theory, long-term security rates are a
weighted average of the yields on all the shorter maturities that make up the longer maturity. This calculation will hold true,
providing that the MRP=0 assumption is valid.

For instance, if the yield on a 1-year bond is 5% and that on a 2-year bond is 6%, the rate on a 1-year bond one year from now
should be 7%, because (1.06) 2 = (1.05)(1.07).

Generally, r designates the rate, or yield, and our notation involves two subscripts. The first subscript denotes when in the
future we expect the yield to exist, and the second denotes the maturity of the security. For instance, the rate expected 3
years from now on a 2-year bond would be denoted by 3r2.

Assuming that expectations theory holds, use the yield information below to back out the following forward rates from the
yield curve.

Expected forward rates, in words: Symbol:

Yield on 1-year bond 1 year from now = r
1 1

Yield on 1-year bond 2 years from now = r

2 1

Yield on 1-year bond 3 years from now = r

3 1

Yield on 1-year bond 4 years from now = r

4 1

Yield on 5-year bond 5 years from now = r

5 5

Yield on 10-year bond 10 years from now = r

10 10

Yield on 20-year bond 10 years from now = r

10 20

Yield on 10-year bond 20 years from now = r

20 10

Maturity Maturity Yield

1 year 1 5.02%
2 year 2 5.31%
3 year 3 5.48%
4 year 4 5.65%
5 year 5 5.73%
10 year 10 5.68%
20 year 20 6.01%
30 year 30 5.92%

(1+ r2)2 = ( (1 + r1) x (1 + 1r1)

1.1090 = ( 1.0502 x (1 + 1r1)
r
1 1 = 5.60%

(1+ r3)3 = ( (1+ r2)2 x (1 + 2r1)

1.1736 = ( 1.1090 x (1 + 2r1)
r
2 1 = 5.82%

(1+ r4)4 = ( (1+ r3)3 x (1 + 3r1)

1.2459 = ( 1.1736 x (1 + 3r1)
 r
3 1 = 6.16%

(1+ r5)5 = ( (1+ r4)4 x (1 + 4r1)

1.3213 = ( 1.2459 x (1 + 4r1)
r
4 1 = 6.05%

(1+ r10)10 = ( (1+ r5)5 x (1 + 5r5)5

1.7375 = ( 1.3213 x (1 + 5r5)5
r
5 5 = 5.63%

(1+ r20)20 = ( (1+ r10)10 x (1 + 10r10)10

3.2132 = ( 1.7375 x (1 + 10r10)10
r
10 10 = 6.34%

(1+ r30)30 = ( (1+ r20)20 x (1 + 20r10)10

5.6149 = ( 3.2132 x (1 + 20r10)10
r
20 10 = 5.74%

The data used to construct the yield curve are readily available, and forward rates can be calculated as shown above. Bond
traders and corporate borrowers can use this information for hedging in the futures market. For example, if a company
plans to build a new plant two years from now and wants to be assured of getting the required funds at a specified rate, then
it can buy a bond futures contract that will enable it to "lock in" the cost of debt for the project. The treasurer would go
through the process described above to determine what the rate two years hence should be on bonds with the desired
maturity.

SOLUTIONS TO SELF-TEST QUESTIONS

Assume the interest rate on a 1-year T-bond is currently 7% and the rate on a 2-year bond is 9%. If the maturity risk
premium is zero, what is a reasonable forecast of the rate on a 1-year bond next year?

1-year Treasury yield 7.0%

2-year Treasury yield 9.0%
Maturity Risk Premium 0.0%

1-year rate, 1 year from now 11.04%

What would the forecast be if the maturity risk premium on the 2-year bond were 0.5% and it was zero for the 1-year bond?

1-year Treasury yield 7.0%

2-year Treasury yield 9.0%
Maturity Risk Premium 0.5%

1-year rate, 1 year from now 10.02%

SECTION 5-3
SOLUTIONS TO SELF-TEST

A bond that matures in six years has a par value of $1,000, an annual coupon payment of $80, and a market interest
rate of 9%. What is its price?

Years to Maturity 6
Annual Payment $80
Par value $1,000
Going rate, rd 9%

Value of bond = $955.14

A bond that matures in 18 years has a par value of $1,000, an annual coupon of 10%, and a market interest rate of 7%.
What is its price?

Years to Maturity 18
Coupon rate 10%
Annual Payment $100
Par value $1,000
Going rate, rd 7%

Value of bond = $1,301.77

SECTION 5-4
SOLUTIONS TO SELF-TEST

Last year a firm issued 30-year, 8% annual coupon bonds at a par value of $1,000. (1) Suppose that one year later the
going rate drops to 6%. What is the new price of the bonds, assuming that they now have 29 years to maturity?

Years to Maturity 29
Coupon rate 8%
Annual Payment $80
Par value $1,000
Going rate, rd 6%

Value of bond = $1,271.81

Suppose instead that one year after issue the going interest rate increases to 10% (rather than 6%). What is the price?

Years to Maturity 29
Coupon rate 8%
Annual Payment $80
Par value $1,000
Going rate, rd 10%

Value of bond = $812.61

SECTION 5-5
SOLUTIONS TO SELF-TEST

A bond has a 25-year maturity, an 8% annual coupon paid semiannually, and a face value of $1,000. The going nominal annual interest rate (r d)
is 6%. What is the bond's price?

Coupons per year 2

Annual values Semiannual Inputs

Years to Maturity 25 50
Coupon rate 8% 4%
Annual Payment $80 $40
Par value $1,000 $1,000
Going rate, rd 6% 3.0%

Value of bond = $1,255.67 $1,257.30

l annual interest rate (r d)
SECTION 5-6
SOLUTIONS TO SELF-TEST

A bond currently sells for $850. It has an eight-year maturity, an annual coupon of $80, and a par value of $1,000. What is its
yield to maturity? What is its current yield?

Years to Maturity 8
Annual Payment $80.00
Current price $850.00
Par value = FV $1,000.00

Going rate, rd =YTM: 10.90%

Annual Payment $80.00

Current price $850.00

Current yield: 9.41%

A bond currently sells for $1,250. It pays a $110 annual coupon and has a 20-year maturity, but it can be called in 5 years at
$1,110. What are its YTM and its YTC? Is it likely to be called if interest rates don't change?

Years to Maturity 20 Years to Call 5

Annual Payment $110 Annual Payment $110
Current price $1,250 Current price $1,250
Par value = FV $1,000 Call price $1,110

YTM 8.38% YTC 6.85%

The company will probably call the bond, because the YTC is less than the YTM.
SECTION 5-9
SOLUTIONS TO SELF-TEST

The yield on a 15-year TIPS is 3 percent and the yield on a 15-year Treasury bond is 5 percent. What is the inflation
premium for a 15-year bond?

Yield on T-Bond 5%
Yield on TIPS 3%

Inflation premium 2%
SECTION 5-10
SOLUTIONS TO SELF-TEST QUESTIONS

Assume that the real risk-free rate is r* = 3% and that the average expected inflation rate is 2.5% for the foreseeable future.
The applicable MRP is 2% for a 20-year bond. What is the yield on a 20-year T-bond (which is default free and trades in a
very active market)?

r* 3.0%
Inflation Premium 2.5%
Maturity Risk Premium 2.0%

Yield 7.5%
SECTION 5-11
SOLUTIONS TO SELF-TEST

A 10-year T-bond has a yield of 4.5 percent. A corporate bond with a rating of AA has a yield of 6.0 percent. If the
corporate bond has excellent liquidty, what is an estimate of the corporate bond’s default risk premium?

Yield on T-Bond 4.5%

Yield on corporate bond 6.0%

Default risk premium 1.5%