SELF-TEST QUESTIONS:

ST-1 Define each of the following terms:

a. Bond; treasury bond; corporate bond; municipal bond; foreign bond
- Bond: A fixed-income instrument and investment product where investors lend money
to a government or a company at a certain interest rate for an amount of time.
- Treasury bond: or T-bond, is long-term debt securities issued by the government by
note.
- Corporate bond: is a type of debt instrument that corporation sell to investors to raise
capital.
- Municiple bond: is a debt security issued by local government, they are often offered
to pay for capital expenditures.
- Foreign bond: is a bond issued in domestic market by a foreign entity in the domestic
market’s currency as a means of raising capital.
b. Par value; maturity date; original maturity
- Par value: or the face value of the bond, the price stated by the issuer in the time of
issuance.
- Maturity date: the date that debt’s principal and interest are due, in which the principal
amount of a note, draft, bond, or loan becomes payable.
- Original maturity: the length of the time until the bond issuer returns the par value of
the bondholder and terminates or redeem the bond.

c. Coupon payment; coupon interest rate

- Coupon payment: annual interest rate paid on a bond
- Coupon interest rate: a nominal yield paid by a fixed-income security

d. Floating-rate bond; zero coupon bond;

- Floating-rate bond: a debt instrument that does not have a fixed coupon rate, but its
interest rate fluctuates based on the benchmark the bond is drawn.
- Zero coupon bond: a debt instrument that does not pay interest but offer a full face
value profits at maturity.

e. Convertible bond; warrant; puttable bond; income bond; discount bond;

premium bond;
- Convertible bond: a fixed-income corporate debt security that yields interests
payments but can be converted into a predetermined number of common stock or equity
shares.
- Warrant: are a derivative that give the right, but not the obligation, to buy or sell a
security (most commonly an equity) at a certain price before expiration.
- Puttable bond: a type of bond that provides the holders of a bond (investors) the right,
not the obligation, to force the issuer to redeem the bond before its maturity date.
- Income bond: is a bond that only promises to pay the capital and does not guarantee
any sort of interest or coupon.
- Discount bond: is a bond that is issued, or trades in the market for less than its par or
face value.
- Premium bond: is a bond trading above its face value or costs more than the face
amount of the bond.

f. Yield to maturity (YTM); yield to call (YTC); current yield;

- Yield to maturity: to measure the total anticipated return of a bond if the bond is
held to its maturity
- Yield to call: the return a bondholder receives if the security is held until the call
date, prior to its date of maturity.

g. Interest rate risk; reinvestment rate risk;

- Interest rate risk: the probability of a decline in the value of an asset resulting from
unexpected fluctuations in interest rates.
- Reinvestment rate risk: the possibility that an investors will be unable to reinvest cash
flows received from an investment, such as coupon payments or interests, at a rate
comparable to their current rate of return

h. Default risk; credit risk;

- Default risk: the likelihood that a borrower won’t be able to make their required
debt payments to a lender.
- Credit risk: Potential of a lender to lose money when they provide funds to a
borrower.
i. Mortgage bond; debenture; subordinated debenture
- Mortgage bond: a bond backed by real estate holdings or real property.
- Debenture: a type of debt instrument that is not backed by any collateral and
usually has a term greater than 10 years
- Subordinated debenture: is an unsecured loan or bond that ranks below other,
more senior loans or security with respect to claims on assets or earnings.

QUESTIONS (7-7; 7-11)

1. Indicate whether each of the following actions will increase or decrease a bond’s
yield to maturity:
a. The bond’s price increases: This would decrease the bond’s YTM. The yield to
maturity and the bond’s price are inversely related. As the price of a bond increases, the
yield decreases, and vice versa.
b. The bond is downgraded by the rating agencies: This would increase the bond’s
YTM. A downgrade indicates increased risk, and investors would demand a higher yield
for taking on that additional risk.
c. A change in the bankruptcy code makes it more difficult for bondholders to
receive payments in the event the firm declares bankruptcy: This would
also increase the bond’s YTM. If it’s more difficult for bondholders to receive payments,
the bond is riskier, and investors would require a higher yield to compensate for this risk.
d. The economy seems to be shifting from a boom to a recession: This
could increase the bond’s YTM, especially if the firm’s credit strength weakens. In a
recession, the risk of default can increase, leading to higher yields. However, if the firm
maintains strong creditworthiness, the impact on YTM might be less pronounced.
e. Investors learn that these bonds are subordinated to another debt issue: This
would increase the bond’s YTM. Subordinated bonds are paid after other debts in the
event of bankruptcy, making them riskier. Investors would demand a higher yield to
compensate for this additional risk.
2. Why are convertibles and bonds with warrants typically offered with lower
coupons than similarly rated straight bonds?
Convertible bonds and bonds with warrants are typically offered with lower coupons than
similarly rated straight bonds due to several reasons:
- Equity Conversion Option: Convertible bonds and bonds with warrants have an
embedded equity conversion option. This means that the bondholder has the
 option to convert the bond into a predetermined number of the company’s
shares. This potential for capital gains can compensate for the lower coupon rate.
- Lower Default Risk: If the issuing company has a lower default risk, it can afford
to offer bonds with a lower coupon rate.
- Investor Demand for Hybrid Securities: Convertible bonds and bonds with
warrants are hybrid securities, offering features of both bonds and stocks. This can
make them more attractive to investors, allowing companies to offer them with
lower coupon rates.
- Flexibility for Issuers: Issuing convertible bonds or bonds with warrants can
provide more flexibility for issuers compared to issuing straight bonds.
- Prevailing Market Conditions: The coupon rate of a bond is also influenced by
prevailing market conditions. In certain market conditions, companies may be able
to issue convertible bonds or bonds with warrants at lower coupon rates

PROBLEMS
7-1Bond valuation: (7-1; 7-3; 7-5; 7-6)
1. Callaghan Motors’ bonds have 10 years remaining to maturity (n=10). Interest is
paid annually; they have a $1,000 par value (M = 1000); the coupon interest rate is 8
percent (i=8%); and the yield to maturity is 9 percent (k = 9%). What is the bond’s
current market price?
n
I [ ( 1+k ) −1] M
PV = n
+ n
=935.82 $
k ( 1+ k ) ( 1+ k )
(I = M × i)

2. Nungesser Corporation’s outstanding bonds have a $1,000 par value (M=1000), a

9 percent semiannual coupon, 8 years to maturity, and an 8.5 percent YTM. What is the
bond’s price?

The payment is: 9%/2= 4.5% semi-annual payment = i

Coupon payment: I = M × i = 4.5% x 1000 = 45%
Number of semiannual periods: n = 8 years/2 = 16 (periods)
YTM in a semi annual period: 8.5%/2 = 4.25%
I [( 1+k )n−1] M
PV = n
+ n
=1028.6 $
k ( 1+ k ) ( 1+ k )
 3. An investor has two bonds in his portfolio that both have a face value of $1,000
(M=1000) and pay a 10 percent annual coupon (i=10%) . Bond L matures in 15 years (m-
L=15), while Bond S matures in 1 year (ms=1).

a. What will the value of each bond be if the going interest rate is 5 percent (k=5%),
8 percent (k=8%), and 12 percent (k=12%)? Assume that there is only one more
interest payment to be made on Bond S (n s=1), at its maturity, and 15 more
payments on Bond L (nL=15).
n
I [ ( 1+k ) −1] M
PV = n
+ n
k ( 1+ k ) ( 1+ k )
(I = M × i)
Interest rate (k) Bond S Bond L
5% $1047.62 $1518.98
8% $1018.52 $1171.19
12% $982.14 $863.78

b. Why does the longer-term bond’s price vary more when interest rates change than
does that of the shorter-term bond?
There are two main reasons:

- There is a greater probability that interest rates will rise (and thus negatively affect
a bond's market price) within a longer time period than within a shorter period. As
a result, investors who buy long-term bonds but then attempt to sell them before
maturity may be faced with a deeply discounted market price when they want to
sell their bonds. With short-term bonds, this risk is not as significant because
interest rates are less likely to substantially change in the short term. Short-term
bonds are also easier to hold until maturity, thereby alleviating an investor's
concern about the effect of interest rate driven changes in the price of bonds.

- Long-term bonds have greater duration than short-term bonds. Because of this, a
given interest rate change will have greater effect on long-term bonds than on
short-term bonds. This concept of duration can be difficult to conceptualize, but
just think of it as the length of time that your bond will be affected by an interest
rate change. For example, suppose interest rates rise today by 0.25%. A bond with
only one coupon payment left until maturity will be underpaying the investor by
0.25% for only one coupon payment. On the other hand, a bond with 20 coupon
payments left will be underpaying the investor for a much longer period. This
 difference in remaining payments will cause a greater drop in a long-term bond's
price than it will in a short-term bond's price when interest rates rise.

4. An investor has two bonds in his or her portfolio, Bond C and Bond Z. Each
matures in 4 years (m=4), has a face value of $1,000 (M=1000), and has a yield to
maturity of 9.6 percent (k=9.6%). Bond C pays a 10 percent annual coupon (i C=10%),
while Bond Z is a zero coupon bond (iZ=0%).
a. Assuming that the yield to maturity of each bond remains at 9.6 percent over the next 4
years, calculate the price of the bonds at the following years to maturity and fill in the
following table:
Years to maturity (n) Bond C Bond Z
4 $1012.79 $693.04
3 $1010.02 $759.57
2 $1006.98 $832.49
1 $1003.65 $912.41
0 $1000 $1000

7-2Current yield and yield to maturity: (7-2; 7-4; 7-9; 7-10)

1. A bond has a $1,000 par value (M=1000), 10 years to maturity (m=10), a 7 percent
annual coupon (i=7%), and sells for $985 (PV=985) (market price).
a. What is its current yield?
Annual interest payment 1000× 7 %
Current yield = = =7.11%
Current market price of thebond 985

b. What is its yield to maturity (YTM)?

- Way 1:
FV = 1000
n
I [ ( 1+k ) −1] M
PV = n
+ n
k ( 1+ k ) ( 1+ k )
¿> k=¿ 7.22%
- Way 2: nên làm theo cnay
Assume that:
 k1 = 7% -> PV1 = 1000
k2 = 8% -> PV2 = 932.9
Because the bond is being sold at 985 (between 1000 and 932), we have:
PV 1−PV
k = k 1+ PV 1−PV 2 × ( k 1−k 2 )
1000−985
¿ 7%+ × ( 8 %−7 % )
1000−932.9
¿ 7.22 %
c. Assume that the yield to maturity remains constant for the next 3 years. What will
the price be 3 years from today?
Time remaining to maturity: n = 10-3 = 7 (years)
I [( 1+k )n−1] M
PV = n
+ n = $989.3
k ( 1+ k ) ( 1+ k )

2. A firm’s bonds have a maturity of 10 years with a $1,000 face value, an 8 percent
annual coupon, and currently sell at a price of $1,100. What are their yield to maturity?
What return should investors expect to earn on this bond?
Assume that:
k1 = 8% -> PV1 = 1000
k2 = 7% -> PV2 = 1070.24
k3 = 6% -> PV3 = 1147.2
Because the bond is being sold at 1100 (between 1000 and 1147.2), we have:
PV 3−PV
k = k 3+ PV 3−PV 2 × ( k 2−k 3 )
1147.2−1100
¿ 6%+ × ( 7 %−6 % )
1 147.2−1070.24
¿ 6 .61 %

3. Heymann Company bonds have 4 years left to maturity (n=4). Interest is paid
annually, and the bonds have a $1,000 par value (M=1000) and a coupon rate of 9 percent
(i=9%).
a. What is the yield to maturity (k) at a current market price of (1) $829 or (2)
$1,104?
1. Assume that:
 k1 = 9% -> PV1 = 1000
k2 = 10% -> PV2 = 968.3
k3 = 11% -> PV3 = 937.95
k4 = 12% -> PV4 = 908.87
k5 = 13% -> PV5 = 881.02
k6 = 14% -> PV6 = 854.31
k7 = 15% -> PV7 = 828.70
Because the bond is being sold at 829 (between 854.31 and 828.70), we have:
PV 6−PV
k = k 6+ PV 6−PV 7 × ( k 7−k 6 )
854.31−829
¿ 14 % + × ( 15 %−14 % )
854.31−828.7
¿ 14. 99 %

2. Assume that:
k1 = 9% -> PV1 = 1000
k2 = 8% -> PV2 = 1033.12
k3 = 7% -> PV3 = 1067.74
k4 = 6% -> PV4 = 1103.95
k5 = 5% -> PV5 = 1141.84
Because the bond is being sold at 1104 (between 1103.95 and 1141.84), we have:
PV 5−PV
k = k 5+ PV 5−PV 4 × ( k 4−k 5 )
1141.84−1104
¿ 5 %+ × ( 7 %−6 % )
1141.84−1103.95
¿6%
(YTM = k)

b. Would you pay $829 for each bond if you thought that a “fair” market interest rate
for such bonds was 12 percent—that is, if rd 12 percent? Explain your answer.
Consider the PV if the interest rate is 12%:
n
I [ ( 1+0.12 ) −1] M
PV = n
+ n
=$ 908.88
0.12 ( 1+0.12 ) ( 1+0.12 )
 - At a price of $829, the yield to maturity, 14.99%, is greater than my required rate
of return of 12%. So I would buy the bond with any price that is lower than
$908.88 because it offers a higher return.

4. Hooper Printing Inc. has bonds outstanding with 9 years left to maturity (n=9).
The bonds have an 8 percent annual coupon rate (i=8%) and were issued 1 year ago at
their par value of $1,000 (M=1000), but due to changes in interest rates, the bond’s
market price has fallen to $901.40 (PV=901.4). The capital gains yield last year was -9.86
percent.
a. What is the yield to maturity?
Assume that:

k1 = 8% -> PV1 = 1000

k2 = 9% -> PV2 = 940.05
k3 = 10% -> PV3 = 884.82
Because the bond’s PV is now 901.4 (between 940.05 and 884.82), we have:
PV 2−PV
k = k 2+ PV 2−PV 3 × ( k 3−k 2 )
940.05−901.4
¿ 9%+ × ( 10 %−9 % )
940.05−884.82
¿ 9. 7 %

b. For the coming year, what is the expected current yield and the expected capital
gains yield?
Current yield = 80/901.4 = 8.88%
Expected capital gains yield = YTM – current yield = 9.69% - 8.88% = 0.81%
COMPREHENSIVE/SPREADSHEET PROBLEM
7-21 Clifford Clark is a recent retiree who is interested in investing some of his savings in
corporate bonds. His financial planner has suggested the following bonds:
* Bond A has a 7 percent annual coupon (i=7%), matures in 12 years (m=12), and has a
$1,000 face value (M=1000).
* Bond B has a 9 percent annual coupon (i=9%), matures in 12 years (m=12), and has a
$1,000 face value (M=1000).
* Bond C has an 11 percent annual coupon(i=11%), matures in 12 years (m=12), and has
a $1,000 face value (M=1000).
Each bond has a yield to maturity of 9 percent (k=9%).
a. Before calculating the prices of the bonds, indicate whether each bond is trading at
a premium, discount, or at par.
Bond A is trading at discount since the coupon rate is lower than YTM
Bond B is trading at par since the coupon rate is equal to YTM
Bond C is trading at premium since the coupon rate is higher than YTM

b. Calculate the price of each of the three bonds.

n
M × i[ ( 1+k ) −1] M
PV = n
+ n
k ( 1+k ) ( 1+ k )
Price of bond A: $856.79
Price of bond B: $1000
Price of bond C: $1143.21
c. Calculate the current yield for each of the three bonds.
Current yield = Coupon payment / PV = (M ×i) / PV = I/PV
Current yield of bond A: 8.17%
Current yield of bond B: 9%
Current yield of bond C: 9.62%
ADDITIONAL HOMEWORK
1. Consider a bond with a 10% coupon and with yield to maturity is 8%. If the
bond’s YTM remain constant, then in one year will the bond price be higher, lower or
unchanged? Why?
A bond's price is inversely related to its yield to maturity. So, if the bond's yield to
maturity remains constant at 8%, then in one year, the bond price will be higher. This is
because the 10% coupon rate on the bond is higher than the yield to maturity.

2. Consider a bond paying a coupon rate of 10% annually when the market interest
rate is only 8%. The bond has three years until maturity. (M=1000)
a. Find the bond’s price today and six months from now after the next coupon is paid
Annual coupon rate :10%
Semi-annual coupon rate: 5%
 Semi-annual coupon payment: 1000 x 5% = $50
Semi-annual YTM: 4%
Time to maturity now is 3 years or 6 semi-annual periods:
6
50[ ( 1+ 4 % ) −1] 1000
PV 1= 6
+ 6
=$ 1052.42
4 % ( 1+ 4 % ) ( 1+4 % )
6 months from now, time to maturity will be 2.5 years or 5 semi-annual periods:
50[ ( 1+ 4 % )5−1] 1000
PV 2= 5
+ 5
=$ 1044.52
4 % (1+ 4 % ) ( 1+ 4 % )
b. What is the total rate of return on the bond?
Rate of return = (PV2 + I – PV1)/PV1 = (1044.52 + 50 –1052.42) / 1052.42 = 4%

3. A bond with a coupon rate of 7% make annual coupon payment on Jan.15 of

each year. The Wall Street Journal reports the ask price is $800 for the bond on Jan.31
at 110:02. What is invoice price of the bond? The coupon period has 360 days.

Accrued Interest =
Days since last coupon payment 16
Annual coupon payment × =1000 ×7 % × =¿$3.11
Days seperating coupon payment 360

Invoice price = Reported ask price + Accrued Interest = 800 + 3.11 = $803.11

4. Consider a bond with a settlement date of Feb.22,2012, and a maturity date of

Mar.15.2020. The coupon rate is 5.5%. If the YTM of the bond is 5.34% (bond
equivalent yield, annually coupon payment), what is the list price of the bond on the
settlement date? What is the accrued interest on bond? What is the full price of the bond?
55 [ ( 1+ 5.34 % )8−1 ] 1000
List price= 8
+ =$ 1010.2
5.34 % ( 1+5.34 % ) ( 1+5.34 % )8
360−22
Accrued interest = 1000 × 5.5% × =$ 51.64
360

Full price = Invoice price = List price + Accrued interest = 1010.2 + 51.64 = $1061.84
5. Compute the value of a 5-year 7.4% coupon bond that pays interest: (1) annually
and (2) semiannually assuming that the appropriate discount rate is 5.6%.
Annual coupon payment: 1000 x 7.4% = $74
 Semi-annual coupon rate: 3.7%
Semi-annual coupon payment: $34
Semi-annual payment period: 10
74 [ ( 1+5.6 % )5−1 ] 1000
Annual PV = 5
+ =$ 1076.65
5.6 % ( 1+5.6 % ) ( 1+5.6 % )5
37 [ ( 1+5.6 % )10−1 ] 1000
Semi-annual PV = 10
+ =$ 857.47
5.6 % ( 1+5.6 % ) ( 1+5.6 % )10

6. A. Assuming annual interest payments, what is the value of a 5-year (m=5) 6.2%
coupon bond (i=6.2%) when the discount rate (k) is (i) 4.5%; (ii) 6.2% and (iii) 7.3%
62 [ (1+ 4.5 % )5−1 ] 1000
PV i= 5
+ =$ 1074.63
4.5 % ( 1+ 4.5 % ) ( 1+ 4.5 % )5
62 [ ( 1+6.2 % )5−1 ] 1000
PV ii = 5
+ =$ 1000
6.2 % (1+ 6.2% ) ( 1+6.2 % )5
62 [ ( 1+ 7.3 % )5 −1 ] 1000
PV iii= 5
+ =$ 955.26
7.3 % ( 1+7.3 % ) ( 1+7.3 % )5

B. Show that the results obtained in part (A) consistent with the relationship
between the coupon rate, discount rate and price relative to par value.
The result showed that bond price is inversely proportional to interest rate (or yield).

7. A 4-year 5.8% coupon bond is selling to yield 7%. The bond pays interest
annually. One year later interest decrease from 7% to 6.2%
a. What is the price of the 4-year 5.8% coupon bond selling to yield 7%.
1000× 5.8 % [ ( 1+7 % )4 −1 ] 1000
PV 1= 4
+ =$ 959. 35
7 % ( 1+7 % ) ( 1+7 % )4
b. What is the price of this bond one year later assuming the yield is unchanged at 7%?
Time left to maturity: 4 - 1 = 3 (years)
1000× 5.8 % [ ( 1+7 % )3−1 ] 1000
PV 2= 3
+ =$ 9 68.51
7 % ( 1+7 % ) (1+7 % )3
c. What is the price of this bond one year later if instead of the yield being unchanged the
yield decrease to 6.2%
 1000× 5.8 % [ ( 1+6.8 % )3−1 ] 1000
PV 3= 3
+ =$ 973.66
6.8 % ( 1+6.8 % ) (1+ 6.8 % )3
d. Complete the following:
Price change attributable to moving to maturity (no change in discount rate)
Price change attribute to an increase in the discount rate from 7% to 6.2%
Total price change

8. What is the value of a 5-year 5.8% annual coupon bond if the appropriate discount
rate for discounting each cashflow is as follow:
Year discount rate (%)
1 5.9
2 6.4
3 6.6
4 6.9
5 7.3

9. A 5-year amortizing security with a par value of $100,000 and a coupon rate of
6.4% has an expected cash flow of $23,998.55 per year assuming no prepayments. The
annual cash flow includes interest and principal payment. What is the value of this
amortizing security assuming no principal prepayments and a discount rate of 7.8%.

10. Suppose that today’s date is April.15. A bond with a 10% coupon paid
semiannually every Jan. 15 and July.15 is listed in The Wall Street Journal as selling at
an ask price of 101:04. If you buy the bond from a dealer today, what price will you pay
for it?
11. Suppose that a bond is purchased between coupon periods. The days between the
settlement date and the next coupon period is d=115. There are 183 days in the coupon
period. Suppose that the bond purchased has a coupon rate of 7.4% and there are 10
semiannual coupon payments remaining.
a. What is the dirty price (total or invoice price) for this bond if a 5.6%
discount rate is used?
Semi-annual YTM: 5.6% / 2 = 2.8%
Semi-annual coupon rate = 7.4% / 2 = 3.7%
 1 9
37 [(1+2.8 %) −1] 1000
Dirty price= 115 ×(37+ 9
+ )=$ 1088.68
(1+2.8 % ) 183 2.8 % (1+2.8 %) (1+2.8 % )9
b. What is the accrued interest for this bond?
Days since last coupon payment
Accrued Interest = Annual coupon payment ×
Days seperating coupon payment
183−115
= 7.4 % ×1000 × =$ 27.5
183
c. What is the clean price (list price)?
Clean price = Dirty price – Accrued interest = 1088.68 – 27.5 = $1061.18

12. Consider a 7.25% coupon, Fannie corporate bond that matures on May 15, 2030.
Calculate the accrued interest for $1 million par value position assuming a settlement
date of October 16, 2007. The last coupon payment was on May 15, 2007. Use the 30/360
day count.

13. Suppose that a U.S. Treasury note maturing August 15, 2009 is purchased with a
settlement date of July 31, 2007. The coupon rate is 3% (i=3%) and the maturity value of
the position is $1,000,000 (M=1,000,000). The next coupon date is August 15, 2007.
a. What is the full (dirty) price of this bond given the required yield is 4.591%?
(Note there are 181 days in the coupon period and there are 15 days between the
settlement date and the next coupon date.)
Semi-annual payment period: 2 years = 4 semi-annual payment
Semi-annual YTM = 4.591% / 2 = 0.022955
Semi-annual coupon payment: 3% x 1,000,000 / 2 = $15,000
1
Dirty price= 15 ×
(1+0.022955) 181
4
15,000[(1+ 0.022955) −1] 1,000,000
(15,000+ 4
+ )=$ 983,074.74
0.022955(1+0.022955) (1+0.022955)4

b. What is the accrued interest? (Note there are 166 days between the last coupon
date and the settlement date.)
Days since last coupon payment
Accrued Interest = Semi−a nnual coupon payment ×
Days seperating coupon payment
181−15
= 15,000× =$ 13,756.91
181
c. What is the flat (clean) price?
Clean price = Dirty price – Accrued interest = 9 83,074.74−13,756.91=$ 969 ,317.83