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What Do Interest kales Mean and What is Their Role in Valuation?

13

Solution: The required nominal rate would he: = 2<7< +6<7 ( = 8%. At this rate, you would expect to have $ 1 ,000 x 1 .08, or $ 1 ,080 at the end of the year. Can you afford the stereo? In theory, the price of the stereo will increase with the rate of inflation. So, one year later, the stereo will cost $1,050 x 1.06, or $1,1 13. You will be short by $33. * A 1 0-year, 7% coupon bond with a face value of $ 1 ,000 is currently selling for $87 1 .65. Compute sour rate of return if you sell the bond next year for $880. 10. Solution:

7? = -

I>,-P

P

70 + 880.10-871.65 -0.09, or 9%. 871.65

9. You have paid $980.30 for an 8% coupon bond with a face value of $ 1,000 that mature in five years. You plan on holding the bond for one year. If you want to earn a 9% rate of return on this investment, \vhat price must you sell the bond for? Is this realistic? Solution: To find the price, solve 80 + /J..-980.30 = 0.09 980.30 for /> ,. 7> =988.53.

J

solution:

Although this appears possible, the yield to maturity when you purchased the bond was 8.5%. At that yield, you only expect the price to be $983.62 next year. In fact, the yield would have to drop to 8.35% for the price to be $988.53. Calculate the duration of a $1,000 6% coupon bond with three years to maturity. Assume that all market interest rates are 7%.

Year Payments PV of Payments Time Weighted 7'Kof Payments Time Weighted PVof Payments Divided by Price

1

60.00 56.07 56.07

2

60.00

3

1060.00 865.28 2595.83

Sum

52.41

104.81

973.76

0.06

0.11

2.67

2.83

This bond has a duration of 2.83 years. Note that the current price of the bond is $973.76, which is the sum of the individual 'VKof payments."

r

Consider the bond in the previous question. Calculate the expected price change if interest rates drop to 6.75% using the duration approximation. Calculate the actual price change using discounted ca>h flow. Solution: Using the duration approximation, the price change would be:

A/> = -DUR x

A/

l+i

x P = -2.83

1.07

x 973.76 = 6.44.

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