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CHAPTER 8

Bond Valuation and the Structure of Interest Rates




8.4 Define yield to maturity. Why is it important?

Yield to maturity (YTM) is the rate of return earned by investors if they buy a bond
today at its market price and hold it to maturity. It is important because it represents
the opportunity cost to the investor or the discount rate that makes the present value of
the bonds cash flows (i.e., its coupons and its principal) equal to the market price. So,
YTM is also referred to as the going market rate or the appropriate discount rate for a
bonds cash flows.
It is important to understand that any investor who buys a bond and holds it to
maturity will have a realized gain equal to the yield to maturity. If the investor sells
before the maturity date, then realized gain will not be equal to the YTM, but will
only be based on cash flows earned to that point. Similarly, for callable bonds,
investors are guaranteed a gain to the point in time when the bond is first called, but
they cannot be assured of the yield to maturity because the issuer could call the bond
before maturity!

8.5 Define interest rate risk. How can the CFOs manage this risk?

The change in a bond's prices caused by changes in interest rates is called interest rate
risk. In other words, we can measure the interest rate risk to a bonds investor by
measuring the percentage change in the bonds price caused by a 1 percent change in the
market interest rates.
The key to managing interest rate risk is to understand the relationships between
interest rates, bond prices, the coupon rate, and the bonds term to maturity. Portfolio
managers need to understand that as interest rates rise bond prices decline, and it
declines more for low-coupon bonds and longer-term bonds than for the others. In such a
scenario, bond portfolio managers can reduce the size and maturity of their portfolio to
reduce the impact of interest rate increases. When interest rates decline, bond prices
increase and rise more for longer-term bonds and higher coupon bonds. At such times,
CFOs can increase the size and maturity of their portfolios to take advantage of the
inverse relationship between interest rates and bond prices.

8.8 Explain what you would assume the yield curve would look like during economic
expansion and why.

At the beginning of an economic expansion, the yield curve tends to be rather steep as
the rates begin to rise once the demand for capital is beginning to pick up due to
growing economic activity. The yield curve will retain its positive slope during the
economic expansion, which reflects the investors expectations that the economy will
grow in the future and that the inflation rates will also rise in the future.

8.9 An investor holds a 10-year bond paying a coupon of 9 percent. The yield to maturity
of the bond is 7.8 percent. Would you expect the investor to be holding a par-value,
premium, or discount bond? What if the yield to maturity was 10.2 percent? Explain.

Since the bonds coupon of 9 percent is greater than the yield to maturity, the bond
will be a premium bond. As market rates of interest drop below the coupon rate of the 9
percent bond, demand for the bond increases, driving up the price of the bond above face
value.
If the yield to maturity is at 10.2 percent, then the bond is paying a lower coupon
than the going market rate and will be less attractive to investors. The demand for the 9
percent bond will decline, driving its price below the face value. This will be a discount
bond.

Questions and Problems

8.26 Lopez Information Systems is planning to issue 10-year bonds. The going market
yield for such bonds is 8.125 percent. Assume that coupon payments will be made
semiannually. The firm is trying to decide between issuing an 8 percent coupon bond
or a zero coupon bond. The company needs to raise $1 million.
a. What will be the price of an 8 percent coupon bond?
b. How many 8 percent coupon bonds would have to be issued?
c. What will be the price of a zero coupon bonds?
d. How many zero coupon bonds will have to be issued?
LO 1, LO 2

Solution:
a. Years to maturity = n = 10
Coupon rate = C = 8.125%
Semiannual coupon = $1,000 (0.08/2) = $40
Current market rate = i = 8.125%
Present value of bond = P
B

0 1 2 3 14

$40 $40 $40 $40

$1,000
( )
( )
$991.55 = + =
+
(
(
(
(


=
+
+
(
(
(
(
(

=
94 . 450 $ 62 . 540 $
) 040625 . 1 (
000 , 1 $
040625 . 0
) 040625 . 1 (
1
1
40 $
2
1
F
2
1
1
1
2
C
P
20
20
n 2
n 2
B
i
2
i
i

The firm can sell these bonds at $991.55.

Enter 20 4.0625% $40 $1,000
N i% PMT PV FV
Answer -$991.55

b. Amount needed to be raised = $1,000,000
Number of bonds sold = $1,000,000 / $991.55 = 1,009

c. Years to maturity = n = 10
Coupon rate = C = 0%
Current market rate = i = 8.125%
Assume semiannual coupon payments.
0 1 2 3 4 5 6 20

$0 $0 $0 $0 $0 $0 $0
$1,000
( )
( )
$450.94 = =
+
=
20 mn
mn
B
040625 . 1
000 , 1 $
m
1
F
P
i


Enter 20 4.0625% $0 $1,000
N i% PMT PV FV
Answer -$450.94

d. At the price of $450.94, the firm needs to raise $1 million. To do so, the firm will
have to issue:
Number of contracts = $1,000,000 / $450.94 = 2,218 contracts

8.27 Showbiz, Inc., has issued eight-year bonds with a coupon of 6.375 percent and
semiannual coupon payments. The markets required rate of return on such bonds is
7.65 percent.
a. What is the market price of these bonds?
b. If the above bond is callable after five years at an 8.5 percent premium on the
face value, what is the expected return on this bond?
LO 2, LO 4

Solution:
a. Years to maturity = n = 8
Coupon rate = C = 6.375%
Semiannual coupon = $1,000 (0.06375/2) = $31.875
Current market rate = i = 7.65%
Present value of bond = P
B


0 1 2 3 16

$31.875 $31.875 $31.875 $31.875
$1,000
( )
( )
$924.75 = + =
+
(
(
(
(


=
+
+
(
(
(
(
(

=
49 . 548 $ 26 . 376 $
) 03825 . 1 (
000 , 1 $
03825 . 0
) 03825 . 1 (
1
1
875 . 31 $
2
1
F
2
1
1
1
2
C
P
16
16
n 2
n 2
B
i
2
i
i

The firm can sell these bonds at $924.75.

b. Purchase price of bond = $924.75
Years investment held = n = 5
Coupon rate = C = 6.375%
Semiannual coupon = $1,000 (0.06375/2) = $31.875
Frequency of payment = m = 2
Realized yield = i
Call price of bond = CP = $1,000 (1.085) = $1,085.00
To compute the expected return, either the trial-and-error approach or the financial
calculator can be used. Try rates higher than the coupon rate.
Try i = 8%, or i/2 = 4%.
10
10
1
1-
(1 2)
2 2 (1 2)
1
1-
$1, 085 (1.04)
$924.75 $31.875
0.04 (1.04)
$258.54 $732.99 $991.53

(
(
+
= + (
+
(
(

(
(
= +
(
(
(

= + =
m n
B m n
C CP i
P
i i

Try a higher rate, i = 9.67% or i/2 = 4.835%.
10
10
1
1
(1 2)
2 2 (1 2)
1
1
$1, 085 (1.04835)
$924.75 $31.875
0.04835 (1.04835)
$248.11 $676.65 $924.77

(
+
= + (
+
(
(

(

(
= +
(
(
(

= + ~
m n
B m n
C CP i
P
i i


The realized rate of return is approximately 9.67% percent. Using a financial
calculator provided an exact yield of 9.6705 percent.

Enter 10 $31.875 -$924.75 $1,085
N i% PMT PV FV
Answer 4.835%
The effective annual yield can be computed as:
( )
2
(1 Quoted rate ) 1
1.04835 1
0.0990 9.90
= +
=
= =
m
EAY m
%