Fin 502 - Business Finance

Homework 2 SOLUTIONS
Winter 2020
Due January 20

1 Individual Questions
1. (1 pt) Suppose a ten year bond has a face value of $1,000, annual coupon payments of $60,
and a market price of $1,150. What is its yield to maturity?

$1,150 = 9t=1 (1+Y$60 $1,060

P
T M )t + (1+Y T M )10
Solve for YTM in excel or with your calculator to get 4.14%.

2. (1pt) The yield to maturity of a $1,000 bond with a 8% coupon rate, semi-annual coupons
and two years to maturity is 6.9% APR, compounded semi-annually. What is its price?

The cash flows are $40 every six months until two years from now at which point it is $1,040.
Since the yield-to-maturity is an APR, compounded semi-annually, the appropriate discount
rate for each cash flow is 6.9/2=3.45%. Thus solve:
price = 3t=1 (1.0345)
$40 $1,040
P
t + (1.0345)4 = $1020.23

3. (4 pts) You are analyzing bond quotes to evaluate an investment strategy for your firm. Un-
fortunately, some entries in the table are missing. You know that the face value is $1,000
and that coupon payments occur annually, the first one in a year from now. Complete all the
necessary information below.

Company Bond Price Coupon Rate Maturity YTM Current Yield

A 5.9% 4 years 5.2%
B $921 7 years 8.9%

The bond price for Company A is found using the formula:

current yield = annual interest
bond price . So after plugging in we get, 0.052 =
0.059∗1000
bond price . Now do some
algebraic manipulations to find the bond price is $1134.62.

The coupon rate for Company B is found using the formula:

current yield = annual interest
bond price . So after plugging in we get, 0.089 =
annual interest
$921 . Now do some
algebraic manipulations to find the annual interest is $81.97. Now divide by face value to see

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 coupon rate is 8.197%.

The YTM for Company A solves:

$59 $59 $59 $1059
$1143.62 = (1+Y T M ) + (1+Y T M )2 + (1+Y T M )3 + (1+Y T M )4 . The solution is then YTM = 2.12%
The YTM for Company B solves:
$81.97 $81.97 $81.97 $81.97 $81.97 $81.97 $1081.97
$921 = (1+Y T M ) + (1+Y T M )2 + (1+Y T M )3 + (1+Y T M )4 + (1+Y T M )5 + + (1+Y T M )6 + (1+Y T M )7 .
The solution is then YTM = 9.81%

4. (2 pt) Suppose that you purchased a bond a year ago and, over the past year, the market
interest rate decreases. What will happen to the price of the bond? Explain the economic
intuition for the change in the bond’s price.

If the interest rate decreases, the price of the bond should increase. This is because we are
discounting our bond by a lower number now. Intuitively, If the interest rate goes down,
newly issued bonds will be less desirable than yours because yours now pays higher interest
than the prevailing market rate. Thus, investors will bid the price of such higher yielding old
bonds up.

5. (1 pt) Consider a 3% coupon Treasury bond with exactly one year to maturity and a face
value of $1,000. Coupons are paid semi-annually. The 1-year rate on the yield curve is quoted
as 2% APR, compounded semi-annually, and the price for a 6-month, $200 STRIP is $198.
What is the price of the bond?
A 3% coupon bond with semi-annual coupons pays a total of $30 (3% of $1,000) every
year,broken into equal semi-annual payments of $15. The bond will also pay its par value
($1,000) at maturity. That is in six months the bond will pay $15 and in one year the bond
will pay $1,015. The 6-month rate for the first 6 months can be found using the 6-month
STRIP price: $200
$198 = 1.0101. The one year rate is 2% APR compounded semi-annually which
is a 6-month rate of 1%. The price of the bond is the sum of its discounted cash flows:
$15 $1,015
P V = 1.0101 + (1.01)2 = $1, 009.85.

2 Group Problem
1. (8 pts) Husky Enterprises would like to raise $15 million to invest in capital expenditures.
The company plans to issue five-year bonds with a face value of $2,000 and a coupon rate
of 6.5%. The coupon rate is quoted as an APR, compounded annually. The following table
summarizes the yield-to-maturity (YTM) for five-year corporate bonds by rating:

Rating AAA AA A BBB BB

YTM% 6% 6.25% 6.5% 6.75% 7%

(a) Assuming the bonds will be rated AA, what will the price of the bonds be?
With face value of $2,000 and coupon rate of 6.5%, the coupon payments will be $2,000
* 0.065 = $130. Then since we assumed a AA rating, the appropriate discount rate is
6.25% (from the table). So the pricing formula is:
P V = 4t=1 (1.0625)
$130 $2,130
P
t + (1.0625)5 = $2, 020.92.

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 (b) Based on the price in part (a), how many bonds must Husky Enterprises issue to raise
$10 million today, assuming the bonds are AA-rated? Since a fraction of a bond cannot
be issued, assume that all fractions are rounded up to the nearest whole number.

Divide $15 million by $2,020.92 and round up to the nearest integer to get 7,423 bonds.
(c) What must the rating of the bonds be for them to sell at par?
For the bonds to sell at par, the coupon rate must equal the yield-to-maturity. Since
the coupon rate is 6.5%, the rating of the bonds must be A for them to sell at par.
(d) Suppose that when the bonds are issued, the price of each bond is $1,959. What is the
likely rating of the bonds? Is this rating considered junk bonds?

Solve for the

P4 YTM$130using the usual formula:
$2,130
$1, 959 = t=1 (1+Y T M )t + (1+Y T M )5
.
After plugging into excel or your calculator you should see that YTM = 7%, thus the
bonds are likely to be rated BB which is considered a junk bond.

2. (4 pt) Suppose the yield curve is flat at 5% and there are two zero-coupon bonds with face
values of $100. Bond 1 is for 30 years with a yield to maturity of 5% and bond 2 is for 5
years with a yield to maturity of 5%. Then suppose the yield curve shifts upwards by one
percentage point across all maturities.
(a) What is the original price of the 30 year bond (at 5% interest)and the price after the
interest rate increases (6% interest)?
$100
Bond 1 Original: 1.05 30 = $23.14
$100
Bond 1 New: 1.0630 = $17.41

(b) What is the original price of the 5 year bond and the price after the interest rate in-
creases?
$100
Bond 2 Original: 1.055 = $78.35
$100
Bond 2 New: 1.06 30 = $74.73

(c) Which of the two bonds see a larger change in price? (in absolute dollar amounts)
Bond 1 Change: $17.41 - $23.14 = -$5.73
Bond 2 Change: $74.73 - $78.35 = -$3.63
So Bond 1’s price will go down by more
3. (3 pts) Suppose a local bank issues a bond with 10 years until maturity, a face value of $1000,
and a coupon rate of 6%. The yield to maturity on this bond when issued is 7%.
(a) What was the price of this bond at issue?
price = 9t=1 (1.07)
$60 $1,060
P
t + (1.07)10 = $929.76

(b) Assuming everything else stays constant, what is the price of this bond immediately
before its
Pfirst coupon payment?
price = 8t=0 (1.07)
$60
t + $1,060
(1.07)9
= $994.85
(c) Assuming everything else stays constant, what is the price of this bond immediately
after its P
first coupon payment?
price = 8t=1 (1.07)
$60 $1,060
t + (1.07)9 = $934.85

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4. (3 pts) You notice that the yield-to-maturity (YTM) of some zero-coupon Treasury bonds are:

Maturity 3-Mo 6-mo 1-yr 1.5-yr

YTM 2% 2.2% 2.5% 2.7%

All of the YTMs are quoted as APRs with semi-annual compounding.

(a) Based on the YTMs above, what is the price of a 1-year zero-coupon corporate bond
with a credit spread of 90 basis points and par value of $1,000?

The cash flow for a 1-year zero-coupon is $1,000 in 1 year. The discount rate for this
bond is the YTM on a 1-year Treasury bond plus the credit spread: 0.025 + 0.009 =
0.034. Then divide by two to get the 6-month discount rate (0.017). Then, the price of
the bond is the present value of its cash flow:
$1,000
PV = (1+0.017) 2 = $966.85

(b) Would the YTM of a 1.5-year 2.7% coupon Treasury bond be more than, less than, or
equal to 2.7%?

The bond’s YTM would be less than 2.7%. The YTM of a 1.5-year zero-coupon bond is
2.7%, since it pays no coupons. The YTM of a 2.7% coupon bond is a weighted average
of the 6 month, 1 year and 1.5 year rates. Since the 6 month and 1 year rates are less
than 2.7%, the average must be less than 2.7%.
(c) Would the YTM of a 1.5-year 12% coupon bond be more than, less than, or equal to
the YTM of a 1.5-year 5% coupon bond? Explain.

The YTM of a 1.5-year 12% coupon bond would be less than the YTM of a 1.5-year 5%
coupon bond. This is because the coupon payments for the 12% bond are twice those
of the coupon payments of the 5% bond. Then, in the weighted average in the YTM
calculation, the 12% bond is putting relatively more weight on the earlier rates, which
are the lower rates. So, the weighted average for the 12% bond must be lower than the
weighted average for the 5% bond.