Which security has a higher effective annual interest rate?

a. Effective annual rate on 3-month T-bill:

100,000
( 97,645 )4 – 1 = 1.024124 – 1 = .10 or 10%

b. Effective annual interest rate on coupon bond paying 5% semiannually:

(1.05)2 – 1 = .1025 or 10.25%

Two bonds have identical times to maturity and coupon rates. One is callable at 105
and the other at 110. Which should have the higher yield?

The bond callable at 105 should sell at a lower price because the call provision is more
valuable to the firm. Therefore, its YTM should be higher.

Consider a bond paying a coupon rate of 10% per year semiannually when the market
interest rate is only 4% per half a year. The bond has 3 years until maturity.

The bond pays $50 every 6 months

Current price $50 × Annuity factor(4%, 6) + $1000 × PV factor(4%, 6) = $1052.42

Assuming the market interest rate remains 4% per half year:

Price 6 months from now =

$50 × Annuity factor(4%, 5) + $1000 × PV factor(4%, 5) = $1044.52

$50 + ($1044.52 – $1052.42)

b. Rate of return = $1052.42

$50 – $7.90 $42.10

= $1052.42 = $1052.42 = .04 or 4% per six months

A bond with a coupon rate of 7% makes semiannual coupon payments on January 15

and July 15 of each year. The quoted price for the bond on January 30 is 100.02.
What is the invoice price of the bond? The coupon period has 182 days.

The reported bond price is 100.02 percent of par, which equals $1,000.20. However, 15
days have passed since the last semiannual coupon was paid, so accrued interest equals $35
× (15/182) = $2.885. The invoice price is the reported price plus accrued interest, or
$1003.085.

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A bond has a current yield of 9% and a yield to maturity of 10%. Is the bond selling
above or below par?

If the yield to maturity is greater than the current yield, the bond must offer the prospect of
price appreciation as it approaches its maturity date. Therefore, the bond must be selling
below par value.

Calculate the real and nominal rates of return on the RRB bond in the second and
third years
Inflation in year
Time just ended Par value Coupon payment Principal repayment
0 $1,000.00
1 2% $1,020.00 $40.80 0
2 3% $1,050.60 $42.02 0
3 1% $1,061.11 $42.44 $1,104.55

The nominal rate of return on the bond in each year is:

interest + price appreciation

Nominal rate of return = initial price .

1 + nominal return
Real rate of return = 1 + inflation −1

Second year Third year

42.02 + 30.60 42.44 + 10.51
Nominal return = 1020 = .071196 1050.60 = .05040

1.071196 1.05040
Real return = 1.03 – 1 = .04, or 4% 1.01 – 1 = .04, or 4%

The real rate of return in each year is precisely the 4% real yield on the bond.

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A 30-year maturity, 8% coupon bond paying coupons semiannually is callable in 5
years at a call price of $1100. The bond currently sells at a yield to maturity of 7%
(3.5% semiannual)

Yield to call:
The bond sells for $1,124.72 based on the 3.5% yield to maturity. [n = 60; i = 3.5%; FV =
1,000; PMT = 40]
Therefore, yield to call is 3.368% semiannually. [n = 10 semiannual periods;
PV = (–)1,124.72 ; FV = 1,100; PMT = 40]

If the call price were $1,050, we would set FV = 1,050 and redo part (a) to find that yield
to call is 2.976%. With a lower call price, the yield to call is lower.

What is the yield to call if the call price is $1,100 but the bond can be called in two
years instead of 5 years?
Yield to call is 3.031% semiannually. [n = 4; (–)PV = 1,124.72 ; FV = 1,100; PMT = 40]

Suppose that today’s date is April 15. A bond with a 10$ coupon paid semiannually
every January 15 and July 15 is listed as selling at an ask price of 101.125. If you buy
the bond a dealer today, what price will you pay for it?

April 15 is midway through the semiannual coupon period. Therefore, the invoice price will
be higher than the stated ask price by an amount equal to one-half of the semiannual
coupon. The ask price is 101.125 percent of par, so the invoice price is:
$1011.25 + ½ × $50 = $1036.25

A newly issued bond pays its coupons once annually. Its coupon rate is 5%, its
maturity is 20 years, and its yield to maturity is 8%. Find the holding-period return
for a one-year investment period if the bond is selling at a yield to maturity of 7% by
the end of the year.

Initial price, P0 = 705.46 [n = 20; PMT = 50; FV = 1000; i = 8]

Next year's price, P1 = 793.29 [n = 19; PMT = 50; FV = 1000; i = 7]

50 + (793.29 – 705.46)
HPR = 705.46 = .1954 = 19.54%

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A 20-year maturity bond with a par value of $1,000 makes semiannual coupon
payments at a coupon rate of 8%. Find the bond equivalent and effective annual yield
to maturity of the bond price if

Selling at $950: Use the following inputs: n = 40, FV = 1000, PV = (–)950, PMT = 40.
You will find that the yield to maturity on a semi-annual basis is 4.26%. This implies a
bond equivalent yield to maturity of 4.26% × 2 = 8.52%.

Effective annual yield to maturity = (1.0426)2 – 1 = .0870 = 8.70%

Since the bond is selling at par ($1000), the yield to maturity on a semi-annual basis is the
same as the semi-annual coupon, 4%. The bond equivalent yield to maturity is 8%.

Effective annual yield to maturity = (1.04)2 – 1 = .0816 = 8.16%

Keeping other inputs unchanged but setting PV = (–)1050, we find a bond equivalent
yield to maturity of 7.52%, or 3.76% on a semi-annual basis.

Effective annual yield to maturity = (1.0376)2 – 1 = .0766 = 7.66%

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