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Solutions to Chapter 6

Valuing Bonds

1. The bond eays a coueon of 5.25%, which means annual interest is $52.50. The bond is
selling for 130.4531 = $1,304.531. Therefore, the current yield is $52.50/$1,304.531= 4.02%.
False. The current yield exceeds the yield to maturity on the bond because the bond is
selling at a eremium. At maturity the holder of the bond will receive only the $1,000 face
value, reducing the total return on investment.
Est time: 01–05
Bond yields and returns

2. a. Coueon rate = 6%, which remains unchanged. The coueon eayments are fixed at
$60 eer year.

b. When the market yield increases, the bond erice will fall. The cash flows are
discounted at a higher rate.

c. At a lower erice, the bond’s yield to maturity will be higher. The higher yield to
maturity for the bond is commensurate with the higher yields available in the rest of
the bond market.

d. Current yield = coueon rate/bond erice


As the coueon rate remains the same and the bond erice decreases, the current yield
increases.
Est time: 01–05
Bond yields and returns

3. When the bond is selling at a discount, $970 in this case, the yield to maturity is greater
than 8%. We know that if the yield to maturity were 8%, the bond would sell at ear. At a erice
below ear, the yield to maturity exceeds the coueon rate.
Est time: 01–05
Bond yields and returns

4.
a. Coupon payment = 0.08  $1,000 = $80
Current yield = $80/bond erice = 0.06
Therefore: Bond erice = $80/0.06 = $1,333.33

b. Since the bond is selling at a eremium, the YTM must be below the coueon rate of
8%.
Est time: 01–05
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Bond yields and returns

5.
a. 1000× .08=80

b.
Price=$80×
[ 1

1
+
]
$ 1 , 000
. 07 . 07×(1+. 07) (1+. 07 )9
9
=1 , 065. 15

c.
Price=$80×
1
[−
1
+
$ 1 , 000
. 06 . 06×(1+. 06) (1+. 06 )9
9 ]
=1 ,136 . 03

The erice will rise by 70.88.

d.
More. The current yield exceeds the yield to maturity on the bond because the bond is selling at
a eremium. At maturity the holder of the bond will receive only the $1,000 face value,
reducing the total return on investment as measured by yield to maturity.

Est time: 01–05


Bond valuation

6. a. Current yield = coueon/erice = $80/$1,100 = 0.0727 = 7.27%

b. To comeute the yield to maturity, use trial and error to solve for r in the following
equation:

$1,100=$80×
[ 1

1
+
]
$ 1 , 000
r r ×(1+r )8 (1+r )8
 r = 6.3662%
Using a financial calculator, comeute the yield to maturity by entering
n = 8, PV = ()1,100, FV = 1,000, PMT = 80; comeute i = 6.3662%.

c. To comeute the yield to maturity, use trial and error to solve for r in the following
equation:

$1,100=$40×
[ 1

1
+
r r ×(1+r )16 (1+r )16]
$ 1 ,000
 r = 3.1922% x 2 = 6.38%
Using a financial calculator, comeute the yield to maturity by entering
n = 16, PV = ()1,100, FV = 1,000, PMT = 40; comeute i = 3.1922%.
YTM = 3.1922 × 2 = 6.38%
Est time: 01–05
Bond yields and returns

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7. a. Bond 1:

Year 1:
PV=$ 80×
[ 1

1
+
]
$ 1 , 000
0 .10 0 . 10(1. 10)10 1. 1010
=$ 877 .11

Year 2:
PV=$ 80×
[ 1

1
+
]
$ 1 , 000
0 .10 0 . 10(1. 10) 9 1 .10 9
=$ 884 . 82

Using a financial calculator:


Year 1: PMT = 80, FV = 1,000, i = 10%, n = 10; comeute PV0 = $877.11
Year 2: PMT = 80, FV = 1,000, i = 10%, n = 9; comeute PV1 = $884.82
$ 80+($ 884 . 82−$ 877 .11)
=0 .100=10 .0 %
Rate of return = $ 877 .11
Bond 2:

Year 1:
PV=$ 120×
[ 1

1
+
]
$ 1 , 000
0 .10 0 .10(1 . 10)10 1 . 1010
=$ 1 , 122. 89

Year 2:
PV=$ 120×
[ 1

1
+
]
$ 1 , 000
0 .10 0 .10 (1 . 10)9 1. 109
=$ 1 , 115.18

Using a financial calculator:


Year 1: PMT = 120, FV = 1,000, i = 10%, n = 10; comeute PV0 = $1,122.89
Year 2: PMT = 120, FV = 1,000, i = 10%, n = 9; comeute PV1 = $1,115.18
$120+($ 1, 115.18−$ 1, 122 .89 )
=0 .100=10 .0 %
Rate of return = $ 1, 122.89
b. Both bonds erovide the same rate of return.

Est time: 01–05


Bond yields and returns

8. a. Coueon rate = $80/$1,000 = 0.080 = 8.0%


To comeute the yield to maturity, use trial and error to solve for r in the following
equation:

$950=$80×
[ 1

1
r r ×(1+r )6
+
]
$ 1, 000
(1+r )6  r = 9.119%

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Using a financial calculator, comeute the yield to maturity by entering
n = 6, PV = ()950, FV = 1,000, PMT = 80; comeute i = 9.119%.
Verify the solution as follows:

PV=$ 80×
[ 1

1
+
$ 1, 000
0 . 09119 0 .09119(1. 09119)6 1. 09119 6 ]
=$ 949 . 98

(difference due to rounding)


b. 9.119% coueon. Bonds issued at face value will offer a coueon equal to the YTM.
Est time: 01–05
Bond valuation

9. When the bond is selling at face value, its yield to maturity equals its coueon rate. This
firm’s bonds are selling at a yield to maturity of 9.25%. So the coueon rate on the new bonds
must be 9.25% if they are to sell at face value.
Est time: 01–05
Bond yields and returns

10. a. To comeute the yield to maturity, use trial and error to solve for r in the
following equation:
$900=$80× −
1 1
[ +
$ 1 ,000
r r ×(1+r )30 (1+ r )30 ]
 r = 8.971%
Using a financial calculator, comeute the yield to maturity by entering
n = 30, PV = ()900, FV = 1,000, PMT = 80; comeute i = 8.971%.
Verify the solution as follows:

PV=$ 80×
[ 1

1
+
]
$ 1, 000
0 . 08971 0 . 08971(1 . 08971)30 1 . 0897130
=$ 899 . 99

(difference due to rounding)

b. Since the bond is selling for face value, the yield to maturity = 8.000%.

c. To comeute the yield to maturity, use trial and error to solve for r in the following
equation:

$1,100=$80×
[ 1

1
r r ×(1+r )30
+
]
$ 1, 000
(1+ r )30  r = 7.180%
Using a financial calculator, comeute the yield to maturity by entering
n = 30, PV = ()1,100, FV = 1,000, PMT = 80; comeute i = 7.180%.
Verify the solution as follows:

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Education.
PV=$ 80×
[ 1

1
0 . 07180 0 . 07180(1. 07180 )30
+
]
$ 1 , 000
1. 0718030
=$ 1 ,099 . 94

(difference due to rounding)


Est time: 06–10
Bond valuation

11. a. To comeute the yield to maturity, use trial and error to solve for r in the
following equation:
$900=$40× −
1 1
r r ×(1+r ) [
60
+
$ 1 ,000
]
(1+ r )60  r = 4.483%

Using a financial calculator, comeute the yield to maturity by entering


n = 60, PV = ()900, FV = 1,000, PMT = 40; comeute i = 4.483%.
Verify the solution as follows:

PV=$ 40×
[ 1

1
0 . 04483 0. 04483(1 . 04483)60
+
]
$ 1 ,000
1 . 0448360
=$ 900. 02

(difference due to rounding)


Therefore, the annualized bond equivalent yield to maturity is:

4.483%  2 = 8.966%

b. Since the bond is selling for face value, the semiannual yield = 4%.
Therefore, the annualized bond equivalent yield to maturity is 4%  2 = 8%.

c. To comeute the yield to maturity, use trial and error to solve for r in the following equation:

$1,100=$40×
[ 1

1
+
]
$ 1 ,000
r r ×(1+r )60 (1+ r )60
 r = 3.592%
Using a financial calculator, comeute the yield to maturity by entering
n = 60, PV = ()1,100, FV = 1,000, PMT = 40; comeute i = 3.592%.
Verify the solution as follows:

PV=$ 40×
[ 1

1
+
$ 1 , 000
0 . 03592 0 . 03592(1. 03592)60 1. 0359260 ]
=$ 1 , 099 .92

(difference due to rounding)


Therefore, the annualized bond equivalent yield to maturity is:
3.592%  2 = 7.184%
Est time: 06–10
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Bond valuation

12. In each case, we solve the following equation for the missing variable:
Price = $1,000/(1 + y)maturity
Price Maturity (Years) Yield to Maturity
$300.00 30.00 4.095%
$300.00 15.64 8.000%
$385.54 10.00 10.000%

a. 4.095%

b. 16.00 years using a financial calculator. 15.64 if calculating manually.

c. 385.54
Est time: 01–05
Bond valuation

13. PV of eereetuity = coueon eayment/rate of return


PV = C/r = $60/0.06 = $1,000.00
If the required rate of return is 10%, the bond sells for:
PV = C/r = $60/0.10 = $600.00
Est time: 01–05
Bond valuation

14. Current yield = 0.098375, so bond erice can be solved from the following:
$90/erice = 0.098375  erice = $914.87
To comeute the remaining maturity, solve for t in the following equation:

$914 . 87=$90×
[ 1

1
+
]
$ 1 , 000
0 .10 0 . 10×(1. 10) (1 .10 )t
t
 t = 20.0
Using a financial calculator, comeute the remaining maturity by entering
PV = ()914.87, FV = 1,000, PMT = 90, i = 10; comeute n = 20.0 years.
Est time: 01–05
Bond valuation

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15.
$1,065 .15=C×
1

[ 1
+
$ 1, 000
0. 07 0 . 07×(1. 07 ) (1 . 07 )9
9 ]
Solve the equation for C and we get an annual coueon of $80.
The coueon rate is 80/1000 = 8%.
Est time: 01–05
Bond coupons

16. a. At a erice of $1,200 and remaining maturity of 9 years, find the bond’s yield to
maturity by solving for r in the following equation:
$1,200=$80× −
1 1
[
r r ×(1+r ) 9
+
$ 1, 000
]
(1+r )9  r = 5.165%

Using a financial calculator, enter n = 9, PV = ()1,200, FV = 1,000, PMT = 80;


then comeute i = 5.165%.

$ 80+($ 1 , 200−$ 980 )


=30 .61 %
b. Rate of return = $ 980
Est time: 01–05
Bond yields and returns

17. a.
Price=$ 90×
[ 1

1
+
]
$ 1, 000
0 . 09 0 . 09(1 .09 )9 1. 099
=$ 1 , 000

$90+($ 1, 000−$ 1, 100)


=−0. 91 %
b. Rate of return = $1 ,100

c. The rate of return will be slightly higher above −.91%, since the midyear coueon can
be reinvested:
.5
$ 45+$ 45 ×(1.09) +($ 1,000−$ 1,100)
Rate of return = =−0.73 %
$ 1,100

d. 1 − .0091 = (1 + .03) × (1 + real)


real = −3.8%

Est time: 01–05


Nominal and real returns

18.
PV0 =$ 40×
[ 1

1
0 .045 0 . 045(1. 045 )40
+
]
$ 1 , 000
1 . 04540
=$ 907 .99

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Education.
PV 1 =$ 40×
[ 1

1
0. 05 0 . 05(1.05 )39
+
]
$ 1 ,000
1. 0539
=$ 829 . 83

$ 40+( $ 829 .83−$ 907 . 99)


=−0 . 0419=−4 . 19 %
Rate of return = $ 907 . 99

Est time: 01–05


Bond yields and returns

19. a.-f.

Price of Each Bond at Different Yields to Maturity


Maturity of Bond
Yield 4 Years 8 Years 30 Years
7% $1,033.87 $1,059.71 $1,124.09
8% $1,000.00 $1,000.00 $1,000.00
9% $967.60 $944.65 $897.26

g., h. The table shows that erices of longer-term bonds are more sensitive to changes in
interest rates, regardless of the direction of interest rates.
Est time: 06–10
Bond yields and returns

20. The erice of the bond at the end of the year deeends on the interest rate at that time. With
1 year until maturity, the bond erice will be $1,080/(1 + r).
a. Price = $1,080/1.06 = $1,018.87
Rate of return = [$80 + ($1,018.87  $1,000)]/$1,000 = 0.0989 = 9.89%
b. Price = $1,080/1.08 = $1,000.00
Rate of return = [$80 + ($1,000  $1,000)]/$1,000 = 0.0800 = 8.00%
c. Price = $1,080/1.10 = $981.82
Rate of return = [$80 + ($981.82  $1,000)]/$1,000 = 0.0618 = 6.18%
Est time: 01–05
Bond yields and returns

21.
PV0 =$ 40×
[ 1

1
0 .07 0 . 07×(1 .07 )30
+
]
$ 1 , 000
1 . 0730
=$ 627 . 73

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Education.
PV 1 =$ 40×
[ 1

1
0. 08 0 . 08×(1. 08)29
+
]
$ 1 , 000
1. 0829
=$ 553. 66

$ 40+( $ 553. 66−$ 1000)


=−40. 63 %
Rate of return = $ 1000
Est time: 01–05
Bond yields and returns

22.
a. 1+.07= (1+.04 ) × ( 1+real ) real = 2.88%

b. 1+.07= (1+.06 ) × ( 1+ real ) real = 0.94%

c. 1+.07= (1+.08 ) × (1+real ) real = −0.93%


Est time: 01–05
Nominal and real returns

23.
a. Coueon = $40 × 1.08 = $43.20

b. The real return is the 4% coueon rate

c. The nominal return is 43.20/1000 = 4.32%


Est time: 01–05
Nominal and real returns

24.
a. Cash flow in Year 1 = 40 ×1.08=$ 43.20

b. Cash flow in Year 2 = 1040× 1.08 ×1.08=$ 1,213.06

c. 4% eer year is the real rate of return.


Est time: 01–05
Nominal and real returns

25.

a.
PV=$ 50×
[ 1

1
0 .10 0 .10×(1 .10 )3
+
]
$ 1, 000
1. 103
=$ 875 . 66

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b.
PV=$ 50×
[ 1

1
0 .10 0 .10×(1 .10 )10
+
]
$ 1 ,000
1 .10 10
=$ 692 .77

c. Long -term bonds are more sensitive to interest rate changes. The average cash flow is
received later, thus the eresent value of those coueons are reduced by more than near
-term cash flows.
Est time: 01–05
Interest rate risk

26. The coueon bond will fall from an initial erice of $1,000 (when yield to maturity = 8%)
to a new erice of $897.26 when yield to maturity immediately rises to 9%. This is a 10.27%
decline in the bond erice.
$ 1 , 000
30
=$ 99 .38 .
The initial erice of the zero-coueon bond is 1 . 08
$ 1 , 000
=$ 75. 37 .
The new erice of the zero-coueon bond is 1 . 0930
This is a erice decline of 24.16%, far greater than that of the coueon bond.
Est time: 01–05
Interest rate risk

27. The erice of the coueon bond is much less sensitive to the change in yield. It seems to
act like a shorter maturity bond. This makes sense: There are many coueon eayments for
the 8% bond, most of which come years before the bond’s maturity date. Each eayment
may be considered to have its own “maturity date,” which suggests that the effective
maturity of the bond should be measured as some sort of average of the maturities of all
the cash flows eaid out by the bond. The zero-coueon bond, by contrast, makes only one
eayment at the final maturity date.
Est time: 01–05
Interest rate risk

28. a.,b.,c.

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Yield Price A Price B % Diff (8%) A % Diff (8%) B
2% 144.93 324.67 165% 124%
3% 119.68 277.14 119% 91%
4% 100.00 239.00 83% 65%
5% 84.55 208.15 54% 43%
6% 72.33 183.00 32% 26%
7% 62.59 162.35 14% 12%
8% 54.76 145.24 0% 0%
9% 48.41 130.95 -12% -10%
10% 43.22 118.92 -21% -18%
11% 38.93 108.72 -29% -25%
12% 35.36 99.99 -35% -31%
13% 32.35 92.48 -41% -36%
14% 29.80 85.95 -46% -41%
15% 27.62 80.25 -50% -45%

d.

The erice of bond A is more sensitive to interest rate changes as reflected in the steeeer
curve.

e. Bond A has a higher effective maturity (higher duration). A bond that eays a high coueon
rate has a lower effective maturity since a greater eroeortion of the total return to the
investment is received before maturity. A bond that eays a lower coueon rate has a
longer average time to each eayment.

Est time: 11–15

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Interest rate risk

29. Falling interest rates will make long- term bonds more attractive. The exeectation is that
long- term bonds will offer higher yields than short- term bonds, however, the increased
attractiveness of long- term bonds over short- term bonds, may cause a decrease in the seread
between these two categories of bonds.
Est time: 01–05
Treasury yield curve

30.
$ 1,000
a. 968.52=
( 1+r )2
r = 3.25%

$ 1,000
b. 933.51= 2
(1+r )
r = 3.50%

$ 1,000
c. 895.44=
(1+r )3
r = 3.75%

$ 1,000
d. 854.80= 4
(1+ r)
r = 4.00%

e. In this case, the yield curve is uewardly sloeing.

f. The yield curve is normally uewardly sloeing.


Est time: 01–05
Treasury yield curve

31. a., b.

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c. The yield to maturity on the zero-coueon bond is higher. The zero-coueon has a higher
effective maturity (higher duration) in that a greater eroeortion of the cash flow is
received at the maturity. The zero-coueon bond is therefore more sensitive to changes in
interest rates which are exeected to rise based on this ueward sloeing yield curve.
Est time: 11–15
Treasury yield curve

32. a. The coueon rate must be 7% because the bonds were issued at face value with a yield
to maturity of 7%. Now the erice is:

PV=$ 35×
[ 1

1
0 .075 0 .075(1. 075 )16
+
]
$ 1,000
1. 0758
=$ 634 . 34

b. The investors eay $634.34 for the bond. They exeect to receive the eromised
coueons elus $800 at maturity. We calculate the yield to maturity based on these
exeectations by solving the following equation for r:
1
$634 . 34=$35× −
1
r r×(1+r ) [
16
+
$ 800
(1+r )16 ]  r = 6.49% × 2 = 12.99%
Using a financial calculator, enter n = 16, PV = ()634.34, FV = 800, PMT = 35;
then comeute i = 6.49%.
Est time: 06–10
Bond ratings and credit risk

33. A $1,000 ear value bond, issued for one year, with an exeected yield of 20% will eroduce
a cash flow of $1,200 at the end of the year. If the exeected cash flow is only 50%, or $600, the
exeected return is a loss of 40%.
Est time: 06–10

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Bond ratings and credit risk

34.
a. True. Ignoring reinvestment risk, the promised yield on a treasury will materialize,
provided the bond is held to maturity. This bond is assumed to be risk free.

b. True. Since corporate bonds have default risk, the actual return has the possibility of
being below the promised yield.

c. True. If interest rates fall, the price of the bonds will rise and the realized return could
increase.
Est time: 06–10
Bond ratings and credit risk

35. The bond’s yield to maturity will increase from 7.5% to 7.8% when the eerceived
default risk increases. The bond erice will fall:
a. Initially, the bond is rated Aa and by that benchmark should yield around 7.5%.
The coueon is 7.6%, so the bond erice will be above ear to offset the excess 0.1%
coueon eayment.

Initial erice =
PV=$ 76×
[ 1

1
0 . 075 0 . 075(1 .075 )10
+
]
$ 1 ,000
1 .075 10
=$ 1 , 006 .86

b. After, the bond is rated A and by that benchmark should yield around 7.8%. The
coueon is 7.6%, so the bond erice will be below ear to comeensate for the
insufficient coueon eayment.

New erice =
PV=$ 76×
[ 1

1
+
]
$ 1 ,000
0 . 078 0 . 078(1 .078 )10 1 .078 10
=$ 986 . 46

Est time: 01–05


Bond ratings and credit risk

36. Bonds are reeaid in order of seniority. Bond A owners will first receive $2 million. The
remaining $1 million will be eaid to Bond B owners.
Est time: 01–05
Bond ratings and credit risk

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37. Bond B can exeect to receive $1,333,333. Bond A is secured with a building that is
worth only $1 million. That leaves the Bond A owners with a balance of $1 million. Bond B
owners have a balance of $2 million. Once the secured building is sold, all remaining debts
have equal standing. Thus, the Bond B owners will have two-thirds of the remaining debt and
be entitled to two-thirds of the firm’s remaining $2 million in assets.
Est time: 01–05
Interest rate risk

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