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Practice

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Q3 page 32

(a) The portfolio manager of a tax-exempt fund is considering investing $500,000 in a debt

instrument that pays an annual interest rate of 5.7% for four years. At the end of four

years, the portfolio manager plans to reinvest the proceeds for three more years and

expects that for the three-year period, an annual interest rate of 7.2% can be earned. What

is the future value of this investment?

(b) Suppose that the portfolio manager in Question 3, part a, has the opportunity to invest

the $500,000 for seven years in a debt obligation that promises to pay an annual interest

rate of 6.1% compounded semiannually. Is this investment alternative more attractive than

the one in Question 3, part a?

(a) The portfolio manager of a tax-exempt fund is considering investing $500,000 in a debt

instrument that pays an annual interest rate of 5.7% for four years. At the end of four

years, the portfolio manager plans to reinvest the proceeds for three more years and

expects that for the three-year period, an annual interest rate of 7.2% can be earned. What

is the future value of this investment?

At the end of year four, the portfolio managers amount is given by: Pn = P0 (1 + r)n. Inserting in

our values, we have P4 = $500,000(1.057)4 = $500,000(1.248245382) = $624,122.66. In three

more years at the end of year seven, the manager amount is given by: P7 = P4(1 + r)3. Inserting in

our values, we have: P7 = $624,122.66(1.072)3 = $624,122.66(1.231925248) = $768,872.47.

(b) Suppose that the portfolio manager in Question 3, part a, has the opportunity to invest

the $500,000 for seven years in a debt obligation that promises to pay an annual interest

rate of 6.1% compounded semiannually. Is this investment alternative more attractive than

the one in Question 3, part a?

At the end of year seven, the portfolio managers amount is given by the following equation,

which adjusts for semiannual compounding. We have: Pn = P0(1 + r/2)2(n). Inserting in our values,

we have P7 = $500,000(1 + 0.061/2)2(7) = $500,000(1.0305)14 = $500,000(1.522901960) =

$761,450.98. Thus, this investment alternative is not more attractive. It is less by the amount of

$761,450.98 $768,872.47 = $7,421.49.

Q8 Page 33

8. Calculate for each of the following bonds the price per $1,000 of par

value assuming semiannual coupon payments.

Bond

Years to Maturity

20

15

10

14

Consider a 9-year 8% coupon bond with a par value of $1,000 and a required yield

of 7%. Given C = 0.08($1,000) / 2 = $40, n = 2(9) = 18 and r = 0.07 / 2 = 0.035,

the present value of the coupon payments is:

1

1

1 r n

P = C

18

1.035

$40

0.035

1 0.538361140

$40

0.035

1 1.857489196

$40

0.035

$40 13.189681727

=

= $527.587.

1+ r

The present value of the par or maturity value of $1,000 is:

$1, 000

1.8574892

$1,000

(1.035)18

$538.361. Thus, the price of the bond (P) = present value of coupon payments +

present value of par value = $527.587 + $538.361 = $1,065.95.

Consider a 20-year 9% coupon bond with a par value of $1,000 and a required yield

of 9%. Given C = 0.09($1,000) / 2 = $45, n = 2(20) = 40 and r = 0.09 / 2 = 0.045,

the present value of the coupon payments is:

1

1 1 r n

P = C

1 1.045 40

$45

0.045

= $45[18.401584] = $828.071.

1 5.81863645

$45

0.045

1 0.1719287

0.045

$45

=

$1, 000

1.045 40

1+ r

$1, 000

5.81863645

$171.929. Thus, the price of the bond (P) = $828.071 + $171.929 = $1,000.00.

[NOTE. We already knew the answer would be $1,000 because the coupon rate

equals the yield to maturity.]

Consider a 15-year 6% coupon bond with a par value of $1,000 and a required yield

of 10%. Given C = 0.06($1,000) / 2 = $30, n = 2(15) = 30 and r = 0.10 / 2 = 0.05,

the present value of the coupon payments is:

1

1 1 r n

P=C

1

1 1.05 30

$30

0.05

1 4.3219424

$30

0.05

1 0.2313774

0.05

$30

=

= $30[15.372451] = $461.174.

$1, 000

1.05 30

1+ r

The present value of the par or maturity value of $1,000 is:

$1,000

4.3219424

$231.377. Thus, the price of the bond (P) = $461.174 + $231.377 = $692.55.

Consider a 14-year 0% coupon bond with a par value of $1,000 and a required yield

of 8%. Given C = 0($1,000) / 2 = $0, n = 2(14) = 28 and r = 0.08 / 2 = 0.04, the

present value of the coupon payments is:

1

1 1 r n

P=C

1

1

(1.04) 28

$0

0.04

1 2.998703319

$0

0.055

1 0.33477471

0.055

$0

coupon rate is zero.]

$1, 000

1.04 28

1+ r n

The present value of the par or maturity value of $1,000 is:

$1, 000

2.99870332

Q5 Page 56

a) Show the cash flows for the following four bonds, each of which has a par value of $1,000

and pays interest semiannually.

Bond

W

X

Y

Z

7

8

9

0

5

7

4

10

Hint: Use your calculator, make PV a negative #

Price

$884.20

$948.90

$967.70

$456.39

Period

Cash Flow

for Bond W

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

$35

$35

$35

$35

$35

$35

$35

$35

$35

$1,035

Cash Flow

for Bond

X

$40

$40

$40

$40

$40

$40

$40

$40

$40

$40

$40

$40

$40

$1,040

Cash Flow

for Bond Y

Cash Flow

for Bond Z

$45

$45

$45

$45

$45

$45

$45

$1,045

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$0

$1,000

b)

Bond W periodic rate 4.99% yield to maturity 10%

Bond Y p.r. 4.997% y.m. 10%

Bond X p.r. 4.49% y.m 9%

Bond Z p.r. 3.99 y.m. 8%

Q7 Page 56

Coupon rate = 11%

Maturity = 18 years

Par value = $1,000

First par call in 13 years

Only put date in five years and putable at par value

Suppose that the market price for this bond $1,169.

(a) Show that the yield to maturity for this bond is 9.077%.

(b) Show that the yield to first par call is 8.793%.

(c) Show that the yield to put is 6.942%.

Q16 Page 56

16. Suppose that an investor with a five-year investment horizon is considering purchasing

a seven-year 9% coupon bond selling at par. The investor expects that he can reinvest the

coupon payments at an annual interest rate of 9.4% and that at the end of the investment

horizon two-year bonds will be selling to offer a yield to maturity of 11.2%. What is the

total return for this bond?

N=5*2=10 i=9.4/2=4.7 PMT=(1000*.09)/2=45 FV=? FV=558.14 This is the coupon

payments and the accrued interest on interest for the 5-year investment horizon

Step 2

PV5=? FV=par=1,000 i=11.2/2=5.6 PMT=45 n=2*2=4 PV 5=961.53

Total $ return is 558.14+961.53 = 1,519.67

Step 3

PV = 1,000 (this is your initial investment)

FV = 1,519.67 (this is your total $ return)

N= 5 years = 10 periods (this is your investment horizon)

Solving for I = 4.27% * 2 = 8.54%

8.54% is your final answer

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