Professional Documents
Culture Documents
Investments Chapter 11
Investments Chapter 11
Summary
Key Terms and Concepts
Discussion Questions
Problems
Case Problems
11.1 The Bond Investment Decisions of Dave and Marlene Carter
11.2 Grace Decides to Immunize Her Portfolio
Key Concepts
1. The important role that interest rates play in the bond investment process and the
basic determinants of market rates
2. The term structure of interest rates and yield curves
3. Fundamentals of bond valuation, including basic measures of yield and return
4. The concept of duration, including effective duration, and its measurement; how duration is
applied in immunizing bond portfolios
5. Various types of bond investment programs and the ways debt securities can be used by
investors; employment of bond ladders is a passive strategy, whereas buying high duration
bonds prior to interest rate drops would be a more active and risky strategy
Overview
1. Interest rates are an integral component of the bond valuation process. Some class time
should be spent discussing the economics of interest rates. The various forces that drive
interest rates should be covered next. In this context, the instructor can introduce the term
structure of interest rates. Inevitably students will ask how the risk-free rate could remain
below the inflation rate for extended periods. This question can be used to open a
discussion of the Federal Reserve, the measures it has available to stimulate the
economy, and the consequences, good and bad, for bond investors.
2. The text then presents three different explanations of the term structure of interest rates: the
expectations hypothesis, the liquidity preference theory, and the market segmentation
theory. The discussion of this important topic should include yield curves, how they are
plotted, and their use in making investment decisions.
3. The next section discusses the bond valuation process. It shows how, given the market rate
of interest and other details regarding the bond (such as the maturity, coupon, and face
value), it is possible to compute the <correct= price of the bond. An example showing this
computation should be worked out in class, illustrating calculator and spreadsheet
applications. The discussion should cover how fluctuations in the market interest rates
induce changes in the price of the bond. Factors affecting the sensitivity of bond prices to
such characteristics as coupon and time to maturity should be illustrated.
4. The concepts of bond yields and returns, along with the computation and use of current
yield, promised yield, yield-to-call, and expected yield, are discussed next. The instructor
may wish to demonstrate financial calculator and spreadsheet techniques for calculating
the yield-to-maturity. It is also important to emphasize that what matters to investors is the
total return from the bond, not just its yield.
5. Bond duration is one of the most important concepts in bond valuation and investing. After
demonstrating the shortcomings of yield-to-maturity, the concept and measurement of
duration can be illustrated. In this regard, the instructor can work out an example to
illustrate how duration and modified duration aid investors in gauging a bond’s price
volatility. Instead of being used to forecast price changes, price changes are calculated and
employed in the process of calculating effective duration.
6. Bond immunization is presented next. This technique preserves the value of a bond
portfolio. Bond immunization involves constructing a bond portfolio with a weighted
average duration that matches the investor’s investment horizon.
7. Bond investment strategies can be either active or passive. Passive investment strategies
include buy-and-hold and bond ladders. Trading on interest rate swings and bond swaps
are considered active strategies. The instructor might point out the advantages and
disadvantages (risks) of each technique.
8. One interesting teaching strategy is to start out with a bond priced at par and show the
decline/rise from an interest rate decrease/increase of the same magnitude. Due to
convexity, bond prices will rise faster than they decline!
Reserve (like changes in the discount rate or federal funds rate). A long period of
artificially low interest rates and a strong economy have made anticipation of Federal
Reserve announcements especially important to bond investors. Individual investors can
monitor interest rates and formulate interest rate expectations on an informal basis through
the use of reports obtained from their brokers, from investor services (e.g., S&P’s
Creditweek), and/or by following columns and articles in such business and financial
publications as the Wall Street Journal or Business Week. The online versions of many
publications, such as the WSJ, update yield curves frequently and report current rates for a
great variety of domestic and foreign debt instruments. If the classroom has an internet
connection, the instructor may want to demonstrate some of these resources.
11.3 The term structure of interest rates is the relationship between the interest rate or yield and
the time to maturity for any class of similar risk securities. The yield curve is just a graphic
representation of the term structure of interest rates at a given point in time. To plot a yield
curve, you need to know the yield-to-maturity for different maturities of similar risk bonds.
As market conditions change, the yield curve’s shape and location also change. Instructors
may ask students to look up current and historical yields on Treasury securities at
www.treasury.gov.
Usually the yield curve has an upward slope. The upward-sloping yield curve indicates that
yields tend to increase with longer maturities. The longer a bond has to go to maturity, the
greater the potential for price volatility and the risk of loss. Thus, investors usually require
higher yields on longer maturity bonds. However, for a variety of reasons, the yield curve
does not always slope upward. For example, if investors expect falling inflation or falling
interest rates, the yield curve may be flat or even downward sloping. Flat yield curves
indicate that yields are the same across maturities. Given that longer-term bonds have more
default and interest rate risk, why would investors hold these bonds if they do not pay
higher returns than do short-term bonds? If investors expect short-term rates to fall, then
locking in a long-term rate now, even if it is only equal to today’s short-term rate, may be a
good idea.
11.4 Analyzing the changes in yield curves over time provides investors with information about
future interest rate movements and how they can affect price behavior and comparative
returns. For example, if over a specific time period, the yield curve begins to rise sharply,
it often means that inflation is increasing. Investors can expect that interest rates, too, will
rise. Under these conditions, most seasoned bond investors would turn to short or
intermediate (three- to five-year) maturities. A downward-sloping yield curve would signal
that rates have peaked and are about to fall, creating opportunities for capital gains.
Differences in yields on different maturities at a particular point in time, or the
<steepness= of the curve, may also provide clues about the future direction of interest rates
and of the economy in general. A very steep yield curve may signal that investors expect
short-term rates to rise in the future. Inverted yield curves may indicate that investors
expect falling rates, and indeed most recessions are preceded by an inverted yield curve.
Even among longer-term maturities, the spread between different longer-term maturities
should be considered before making a decision to invest. For example, if the spread
between 10- and 30-year maturities is not large enough (say, less than 20 basis points),
then the investor should favor the 10-year bond because he would not gain enough to
compensate for investing in the much riskier 30-year maturity. In any case, the investor
would have to consider his or her own risk tolerance to determine whether the risk
premium was sufficient for the additional risk of buying longer-term securities.
11.5 Bond prices are driven by market yields. In the marketplace, the appropriate yield at which
the bond should sell is determined first, and then that yield is used to find the price of the
bond. The yield is a function of certain market and economic forces, such as the risk-free
rate and inflation, as well as key issue and issuer characteristics, such as the maturity of the
issue and agency rating (i.e., risk) assigned to the bond.
You cannot value a bond without knowing its market yield, which functions as the discount
rate in the bond valuation process. You could look up the price through one of the public
or broker-provided websites, but that price would have been calculated using the market
yield.
11.6 Bonds are usually priced using semiannual compounding because in practice, most bonds
pay interest every six months. Semiannual compounding makes discounting of semiannual
coupon payments more precise, resulting in more accurate valuation. However, using
annual compounding simplifies the valuation process a bit and does not make very much
difference in value, especially when interest rates are very low and maturities are short.
With higher interest rates and longer maturities, the difference increases. Bonds offering
semiannual payments will be priced slightly higher if the bonds sell at a premium and
slightly lower if they are selling at a discount.
11.7 Current yield is a measure of a bond’s current income. It is the amount of current income
that a bond provides relative to its prevailing market price. Yield-to-maturity is a more
complete measure and evaluates both interest income and price appreciation to assess a
bond’s overall return. Yield-to-maturity indicates the fully compounded rate of return
earned by an investor, given that the bond is held to maturity and all principal and
interest payments are made in a prompt and timely fashion.
Promised yield is the same as yield-to-maturity. Promised yield is computed assuming the
bond is held to maturity. Realized yield is the rate of return an investor can expect to earn
by holding a bond over a period of time that is less than the life of the issue. Realized yield
is used by bond traders who trade in and out of bonds over short holding periods. Yield to
call is the yield the investor would earn assuming the bond is called on its first call date.
11.8 When we are dealing with semiannual cash flows, to be technically correct, we should find
the bond’s <effective= annual yield. However, the market convention for finding the
annual yield is simply to double the semiannual yield. This practice produces what the
market refers to as the bond-equivalent yield. Thus, given a semiannual yield of 4%,
according to the bond-equivalent yield convention, the annual rate of return of this bond if
held to maturity is 8%. This is also the same as the bond’s promised yield or yield-to-
maturity.
11.10 Duration is a measure that captures the timing and magnitude of a bond’s cash payments,
and it is helpful in assessing the interest rate exposure of a bond. Duration is a kind of
weighted average maturity, where each payment that a bond makes receives some weight,
and the weight depends not only on the size of the cash payment but also on when the
payment is made. Duration captures both price and reinvestment risks in a single measure
and indicates how a bond’s price will react to interest rate changes. A bond’s maturity is
just a fixed number when the last payment is made. A bond’s maturity is not influenced
by the size and timing of coupon payments and therefore a bond’s maturity is not as
accurate as is its duration in assessing the bond’s interest rate risk.
Modified duration is a simple calculation that makes a direct link between a bond’s
duration and the extent to which its price reacts to interest rate changes. A bond’s modified
duration is simply equal to its duration divided by one plus its yield to maturity. To assess
the interest rate risk of a particular bond, calculate its modified duration, and then, the
change in bond price based upon a change in interest rates can be computed as follows:
Percent change in bond price 1 Modified duration Change in interest rates
Like modified duration, effective duration calculates the approximate percentage change in
a bond’s price that would result from a given change in interest rates. Unlike modified
duration, it does not assume that the bond will be held until it reaches its maturity, so it is
more useful for bonds with embedded options (callable, putable, convertible, etc.). The
formula for computing effective duration is
BP(ri ) BP ri
ED .
2 BP ri
11.11 Market interest rate changes have two effects: the price effect and the reinvestment effect,
which occur in opposite directions. When a bond portfolio is immunized, these two effects
exactly offset each other and leave the value of the portfolio unchanged. This happens
when the weighted average duration of the bond portfolio is exactly equal to the desired
investment horizon. If a portfolio is constructed and continuously rebalanced such that the
weighted average duration is equal to the desired investment horizon at any particular point
in time, then the portfolio is said to be immunized from the effects of interest rate changes.
Bond immunization allows an investor to derive a specified rate of return from bond
investments regardless of what happens to market interest rates over the course of the
holding period. That is, the investor’s bond portfolio is <immunized= from the effects of
changes in market interest rates over a given investment horizon.
Portfolio immunization is not a passive investment strategy; it requires continual portfolio
rebalancing on the part of the investor in order to maintain a fully immunized portfolio.
The composition of the portfolio should change every time interest rates change, and also
with the passage of time.
11.12 Bond ladders are a passive investment strategy whereby an equal amount of money is
invested in a series of bonds with staggered maturities. Suppose an investor wants to
confine her investing to fixed income securities with maturities of 10 years or less. She
could set up the ladder by investing in roughly equal amounts of 3-, 5-, 7-, and 10-year
issues. When the 3-year issue matures, the proceeds would be reinvested in a new 10-year
note. Similar rollovers would occur whenever a bond matures. Eventually, the investor
would hold a full ladder of staggered 10-year notes. Rolling into new 10-year issues every
2 or 3 years allows the investor to do a kind of dollar cost averaging and thereby lessen
the impact of swings in market rates.
Tax swaps involve replacing a bond with a capital loss with a similar security. By selling
the bond with the capital loss, an investor can offset a capital gain generated in another
part of the portfolio and thereby reduce the overall tax liability. Identical issues cannot be
used for this kind of swap; the IRS will rule such swaps as <wash sales= and therefore
disallow the capital loss.
11.13 An aggressive bond investor would employ the highly risky forecasted interest rate
behavior strategy. The intent of this strategy is to take advantage of interest rate swings by
timing the market. Usually these swings are short lived, so aggressive bond traders will try
to magnify their returns by trading on margin. These investors try to generate capital gains
when interest rates are expected to decline and to preserve capital when interest rates are
expected to rise.
11.14 The interest sensitivity of a bond determines how much the bond’s price will fluctuate for a
given change in interest rates. Obviously, when rates drop, bond traders want to capitalize
on this and, as such, require issues that will respond to these interest rate changes. Bonds
with longer maturities and/or lower coupons respond more vigorously to changes in
market rates; therefore, they undergo greater price swings. High-grade issues are widely
used by active bond traders since these issues are generally more interest-sensitive than
lower-rated bonds4for example, market behavior is such that a Triple A corporate will
generally be far more responsive to interest rates than a Triple B issue. A deteriorating
economy will
result in a decline in the demand for money and hence interest rates, but it might cause
more default risk to the holder of the Triple B bond issue.
11.4 a. An aggressive investor would be more concerned with capital gains, that is, price
appreciation. If she believes that interest rates are headed down, then she should invest
in high-grade bonds with long durations (i.e., bonds with low coupons and long
maturities). If she believes that rates are headed up or unlikely to change much, then
she might invest in junk bonds which offer higher yields and the potential of price
appreciation if the credit condition of the issuer improves.
b. A very conservative investor might include only short-term, investment-grade
corporate, government, and municipal bonds in her portfolio. This would produce a
minimum of market losses and risk.
c. 1. An insurance company, pension fund, or sophisticated retiree that must rely on
predictable income streams
2. An investor who wants to maximize yield
3. An individual or institution that is conservative and wants to dollar cost average the
bond returns in their portfolio.
4. Zero coupon bonds typically appeal to investors who have a buy-and-hold
investment strategy and a specific date, such as retirement or a child entering
college, at which the funds will be needed. However, they are the only bonds whose
durations equal their maturities, and the most price sensitive in response to interest
rate changes, so aggressive investors would also like zeroes if they expect interest
rates to fall.
11.5 Answers will vary with each student.
Solutions to Problems
11.1 a.
U.S. Treasury Security Maturity (mos.) Yield
A 12 12.6%
B 120 11.2%
C 6 13.0%
D 240 11.0%
E 60 11.4%
Yed
13.5%
13.0%
12.5%
12.0%
11.5%
11.0%
10.5%
0 50 100 150 200 250 300
b. The yield curve is clearly downward sloping such as was seen in the 1970s.
Expectations theory would interpret such a curve as forecasting lower rates, perhaps
because of lower inflation, in the future.
I = 3.5 I=7
FV = 1000 FV = 1000
CPT CPT
PV = 31,275.88 PV = 31,273.24
= pv(.035,30,50,1000) = pv(.07,15,100,1000)
Semiannual compounding Annual compounding
N = 20 N = 10
I=5 I = 10
PMT = 30 PMT = 60
FV = 1000 FV = 1000
CPT CPT
PV = 3750.76
PV = 3754.22
= pv(.05,20,30,1000)
= pv(0.10,10,60,1000)
Semiannual compounding Annual compounding
N = 40 N = 20
I = 4.5 I=9
PMT = 55 PMT = 110
FV = 1000 FV = 1000
CPT CPT
PV = 31,184.02 PV = 31,182.57
= pv(.045,40,55,1000) = pv(.09,20,110,1000)
Semiannual compounding results in a slightly lower price if the bond is discounted and a
slightly higher price if the bond is selling at a premium.
11.5 Annual compounding
N = 25
I = 7.6
PMT = 90
FV = 1000
CPT
PV = 31,154.70
Or in Excel use = pv(.076,25,90,1000)
11.6 Semiannual compounding
N = 10
I=4
PV = 3800
FV = 1000
CPT
PMT = 15.34
Coupon rate = 3.068%
Or in Excel use = pmt(0.04,10,-800,1000) which gives a semiannual payment of $15.34.
Double that to get the annual coupon of $30.68, and divide that by the $1,000 par value to
get the 3.068 coupon rate.
11.7 N = 30
I=3
PMT = 40
FV = 1000
CPT
PV = -1,196.00
Or in Excel use = pv(.03,30,40,1000)
11.8
Years to Required
Bond Par Value Coupon Maturity Return Value
A $ 1,000 11.00% 20 12.00% ($925.31)
B $ 1,000 8.00% 16 8.00% ($1,000.00)
C $ 100 9.00% 8 7.00% ($111.94)
D $ 500 6.00% 13 8.00% ($420.96)
E $ 1,000 7.00% 10 5.00% ($1,154.43)
11.9
Years to Required
Bond Par Value Coupon Maturity Return Value
A $ 1,000 10.00% 12 8.00% ($1,152.47)
B $ 1,000 12.00% 20 12.00% ($1,000.00)
C $ 500 12.00% 5 14.00% ($464.88)
D $ 1,000 14.00% 10 10.00% ($1,249.24)
E $ 100 6.00% 4 14.00% ($76.11)
11.10 N = 6
PV = 3975
PMT = 50
FV = 1050
CPT
I = 6.225
Bond equivalent yield = 6.225 x 2 = 12.45%
In Excel use = rate(6,50,-975,1050) to get the semiannual yield of 6.225%, then double that
to find the ytm/bond equivalent yield of 12.45%.
11.13 To find the current yield, we need to know the coupon payment computed as
follows. N = 18
I=6
PV = -937
FV = 1000
PMT = 54.18
This is a semi-annual payment, so the annual payment is $108.36.
The current yield is $108.36/937 = 11.56%
In Excel use = pmt(0.06,18,-937,1000) to get semi-annual payment of $54.18. To get the
current yield, you double this payment and divide by price, so $108.36/937 = 11.56%.
11.14 Purchase Price
N = 15
I=8
PMT = 60
FV = 1000
CPT
PV = 3828.81
In Excel use =PV(0.08,15,60,1000)
Price in 1 year
N = 14
I=7
PMT = 60
FV = 1000
CPT
PV = 3912.55 HPR = (912.55-828.81 + 60) /828.81 = 17.34%
In Excel use =PV(0.07,14,60,1000) to get 3$912.55. HPR = (912.55 3 828.81 + 60)/828.81
= 17.34%
11.15
Promised yield, annual compounding
N = 20
PV = 31070
PMT = 110
FV = 1000
CPT I = 10.17% promised yield
In Excel use = rate(20,110,-1070,1000)
11.16 a and b
A
8% 5 15 $ 110 $ 1,000 $1,119.78 $1,256.78
11% 5 15 $ 110 $ 1,000 $1,000.00 $1,000.00
14% 5 15 $ 110 $ 1,000 $897.01 $815.73
c. The table clearly shows that price sensitivity to changes in interest rates increases
as the years to maturity increase.
d. If Lynn wants to minimize interest rate risk, she should choose the 5-year bond.
11.17 Yield to Maturity
N = 15
PV = 31085.96
PMT = 80
FV = 1000
CPT I = 7.05%
In Excel use =RATE(15,80,-1085.96,1000)
11.18
Annual
Interest Yrs to Current Yield to
Bond Par Value PMT Maturity Value Maturity
A $ 1,000 $ 90 8 $ 820 12.71%
B $ 1,000 $ 120 16 $ 1,000 12.00%
C $ 500 $ 60 12 $ 560 10.22%
D $ 1,000 $ 150 10 $ 1,120 12.81%
E $ 1,000 $ 50 3 $ 900 8.95%
If the market rate is above the coupon rate, the bond will trade at a discount (below par); if
it is below the coupon rate, the bond will trade at a premium (above par). All bonds
approach par value as they get nearer to maturity, so the longer the time to maturity, the
greater the effect that differences between the two rates will have.
11.27 N = 3, PV = -850, PMT = 100, FV = 975, I = 15.96. The yield on this investment would be
15.96%. If the investor sold the bond for $975 after 9 month and the price included
accrued interest, his HPR would be ($975 3 $850)/$975 = 7.69%. If it did not include
accrued interest, the HPR would be ($975 3 850 + 100*9/12)/$975 = 15.38%.
11.28
This problem illustrates that bonds selling at a price above the call price are likely to be
called, while those selling below their call price probably will not be called.
11.29 Modified duration Macaulay duration/(1 Yield) 9.8/1.08 9.07
11.30 Percent change in bond price 1 Modified duration Change in interest rates
Modified duration Macaulay duration/(1 Yield) 8.24/1.07 7.70%
Now suppose the bond yield goes up by 0.005 from 7% to 7.5%.
Percent change in bond price 1 7.70 0.005 0.0385 or 3.85%.
If the yield goes down by 0.005, then the percentage change in the bond price is positive
3.85%.
11.31
N 50 50 50
I 3.25 3.5 3.75
PMT 30 30 30
FV 1000 1000 1000
PV (Price) 938.62 882.72 831.74
ED 938.62 831.74
12.11 years
2 882.72
0.005
The effective duration is 12.11 years.
11.32
PV of CF as Column l
Time Cash Flow PV of CF,7% % of bond x Column 4
1 90 84.11 7.12% 0.0711513
2 90 78.61 6.65% 0.1329932
3 90 73.47 6.21% 0.186439
4 90 68.66 5.81% 0.2323228
5 90 64.17 5.43% 0.2714051
6 90 59.97 5.07% 0.3043795
7 90 56.05 4.74% 0.331878
8 90 52.38 4.43% 0.3544758
9 90 48.95 4.14% 0.3726966
10 90 45.75 3.87% 0.3870162
11 90 42.76 3.62% 0.3978671
12 90 39.96 3.38% 0.4056419
13 90 37.35 3.16% 0.4106966
14 90 34.90 2.95% 0.4133539
15 1090 395.07 33.42% 5.0128587
1,182.16 9.2851757
The difference is partly due to small rounding errors and mostly due to the fact that
modified duration is most accurate for predicting small changes in interest rates while 1%
is a fairly large increase.
11.33 This question is about bond price volatility. We need to measure the responsiveness of a
bond’s price to a given change in market interest rates. To maximize capital gains, we
need to select the bond that has the maximum price volatility. To do this, first calculate the
modified duration of each bond using the following formula:
Duration in years
Modified duration
I Yield-to-maturity
Then calculate the price change with the following formula:
% change in bond price 1 Modified duration Change in interest rates
a. Bond with duration of 8.36 years with YTM of 7.5%:
Modified duration 8.36/(1 + 0.0725) = 7.79
% change in bond price 1 7.79 0.5% %
b. Bond with duration of 9.23 years with YTM of 10%:
Modified duration 9.23/(1 + 0.0986) = 8.40 = 8.40
% change in price 1 8.40 0.5% 4.20%
c. Bond with duration of 8.68 years with YTM of 5.75%:
Modified duration 8.68/(1 + 0.0594) = 8.19
% change in price 1 8.19 0.5% 4.10%
Bond b is the most sensitive to rate changes, so if we think rates will drop and bond prices
will rise, bond b will increase in value more than bonds a and c.
11.34 Current price of the bonds at 9% market interest:
Zero-coupon bond:
Bond 1 Bond 2
N = 25,24 N = 20,19
I = 9,7 I = 9,7
PMT = 0 PMT = 75
FV = 1000 FV = 1000
CPT CPT
PV = 3115.97, 3197.15 PV = 3863.07, 31051.68
Capital gains:
Zero-coupon bond: Gain $197.15 $115.97 $81.18
7.5% bond: Gain $1,051.68 863.07 $188.61
To maximize the dollar value of capital gains per bond, buy the 7.5%, 20-year bond, but
this doesn’t take into account the big difference in the amount (cost) invested. The
percentage capital gain on the zero-coupon bond is 70%, whereas on the 20-year bond the
percentage gain is just under 22%. Usually investors should focus on the total return rather
than just the capital gain or the income. To do that, we should compare holding period
returns:
Interest Capital gains
HPR Purchase price
Zero-coupon bond: HPR (197.15 3 115.97)/115.97 = 70.0%
b.
Time CF PV of CF % of Price (l) x (4)
1 78.75 73.19 0.07 0.07
2 78.75 68.02 0.07 0.13
3 78.75 63.21 0.06 0.19
4 78.75 58.75 0.06 0.23
5 78.75 54.60 0.05 0.27
6 78.75 50.74 0.05 0.30
7 78.75 47.16 0.05 0.32
8 78.75 43.83 0.04 0.34
9 78.75 40.73 0.04 0.36
10 78.75 37.86 0.04 0.37
11 78.75 35.18 0.03 0.38
12 78.75 32.70 0.03 0.38
13 78.75 30.39 0.03 0.39
14 78.75 28.24 0.03 0.39
15 1078.75 359.53 0.35 5.27
1024.12 9.37
c. The zero-coupon bond’s duration is equal to its maturity, 20 years. The modified
duration is then 20/1.0822 = 18.48
d.
Time CF PV of CF % of Price (l) (4)
1 75 69.51 0.07 0.07
2 75 64.42 0.07 0.13
3 75 59.70 0.06 0.19
4 75 55.33 0.06 0.23
5 75 51.28 0.05 0.27
6 75 47.53 0.05 0.30
7 75 44.05 0.05 0.32
8 75 40.82 0.04 0.34
9 75 37.83 0.04 0.36
10 75 35.06 0.04 0.37
11 75 32.50 0.03 0.37
12 75 30.12 0.03 0.38
13 75 27.91 0.03 0.38
14 75 25.87 0.03 0.38
15 75 23.97 0.03 0.38
16 75 22.22 0.02 0.37
17 75 20.59 0.02 0.37
18 75 19.08 0.02 0.36
11.36
Periods to Yield to Coupon Par
Bond Maturity Maturity Payment Value Value
a. Value today 23 6.76% $ 56.25 $ 1,000 ($869.40)
c. Value with semi-annual
payments 46 3.38% $ 28.13 $ 1,000 ($868.49)
d. Value, ytm = 5.625% 23 5.625% $ 56.25 $ 1,000 ($1,000.00)
Value, ytm = 8% 23 8.00% $ 56.25 $ 1,000 ($753.69)
Value, ytm = 4.5% 23 4.50% $ 56.25 $ 1,000 ($1,159.16)
Value, Jay & Austin
bond, semi-annual 44 3.82% $ 32.50 $ 1,000 ($878.74)
payments
b. Current yield = $56.25/$869.40 = 6.47%
d. The value changes in simply confirm that values move inversely with changes
in interest rates and that when YTM = Coupon rate, the bond will always be valued at par.
e. The Jay & Austin bond's yield to maturity is the semi-annual yield x 2 = 7.65%.
FV = 948.14
CPT
I = 14.07%
4. Although this appears to be an attractive investment, one must compare the expected
return with other possible alternatives. Presuming the expected rate of return (of 14%)
is commensurate with the exposure to risk, Dave and Marlene should seriously
consider this bond investment opportunity4unless they feel strongly that they can do
better elsewhere. Further, they should be well aware of the fact that this high rate of
return is due in large part to their ability to correctly forecast interest rates (no easy
task); they should fully appreciate the implications of this kind of risk exposure.
b. 1. We will evaluate the current and promised yields using the text’s formulas.
Current Yield Annual Interest/Current Price
Beta Corporation $70/$785 8.92%
Dental Floss, Inc. $75/$780 9.62%
Root Canal Products $65/$885 7.35%
Kansas City Dental Insurance $80/$950 8.42%
Beta Corporation:
YTM computation
N = 26
PV = 3785
PMT = 35
FV = 1000
CPT
I = 4.99% x 2 = 9.98%
Dental Floss, Inc.:
The r% can be using a financial calculator; the expected return is 4.94% 2 9.89%
(based on 25 years or 50 periods).
Root Canal Products:
The r% can be using a financial calculator; the expected return is 3.97% 2 7.93%
(based on 13 years or 26 periods).
Kansas City Dental Insurance:
The r% can be calculated using a financial calculator; the expected return is
4.31% 2 8.62%.
2. Dental Floss offers higher current but slightly lower promised yield than Beta
Corporation.
3. Depending on whether The Carters are investing for current income or long term
return, they could swap Beta for Dental Floss to obtain higher current income; this
presumes the two have equal default risk and that the Carters are sure the two are
of comparable quality.
Bond 4:
Duration
PV of CF as Column l
Computation
Cash
Time PV of CF,9.5l% % of bond price x Column 4
Flow
1 92.5 84.47 8.62% 0.08619448
2 92.5 77.14 7.87% 0.15742483
3 92.5 70.44 7.19% 0.21563948
4 92.5 64.33 6.56% 0.26256136
5 92.5 58.74 5.99% 0.29971233
6 92.5 53.64 5.47% 0.32843516
7 92.5 48.99 5.00% 0.34991312
8 92.5 44.74 4.56% 0.36518755
9 92.5 40.85 4.17% 0.3751736
10 92.5 37.31 3.81% 0.3806743
11 92.5 34.07 3.48% 0.38239309
12 92.5 31.11 3.17% 0.38094509
13 92.5 28.41 2.90% 0.37686715
14 92.5 25.94 2.65% 0.37062674
15 1092.5 279.82 28.55% 4.28295466
980.00 2876.62% 8.61470294
15 years, 9.25% coupon; currently priced at $980 to yield 9.51%
Using Excel, duration of this bond is 8.615 years.
Modified duration 8.615 / 1.0951 = 7.87
Percent change in bond price 1 Modified duration Change in interest rate
1 x 7.87 0.75
5.90%
The price of the bond will fall by 5.90% if interest rate rises 0.75% and vice versa.
c. When Grace invests $50,000 in each of the four bonds, the weighted average duration of
the bond portfolio would be:
(l) (2) (3) (4) (5) (6)
Bond Particulars Amount Weight Bond Weighted
Invested Duration Duration
(4) x (5)
Bond 1 12 years, 7.50% $ 50,000 0.25 8.1 2.025
Bond 2 10 years, zero 50,000 0.25 10.0 2.500
Bond 3 10 years, 10% 50,000 0.25 6.9 1.725
Bond 4 15 years, 9.25% 50,000 0.25 8.62 2.154
$200,000 1.00 8.404
The duration of the portfolio is 8.4 years. Grace’s investment horizon is 7 years; therefore,
the bond portfolio is not immunized because the weighted average of the portfolio is greater