 Solutions to Problems

1. Calculator solution is:

N = 10
I=3
PMT = 40
FV = 1000
CPT
PV = –1085.30

3. a. Semiannual compounding Annual compounding

N = 30 N = 15
I=4 I=8
PMT = 52.50 PMT = 105
FV = 1000 FV = 1000
CPT CPT
PV = –1,216.15 PV = –1,213.99
b. Semiannual compounding Annual compounding
N = 20 N = 10
I=4 I=8
PMT = 35 PMT = 70
FV = 1000 FV = 1000
CPT CPT
PV = –932.05 PV = –932.90
c. Semiannual compounding Annual compounding
N = 40 N = 20
I=5 I = 10
PMT = 60 PMT = 120
FV = 1000 FV = 1000
CPT CPT
PV = –1,171.59 PV = –1,170.27

5. Semiannual compounding
N = 10
I=4
PV = –800
FV = 1000
CPT
PMT = 15.34
Coupon rate = 3.068%

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 11

 7. Holding Period Return = ($100+ $50)/ $900 = 16.67%

9. N = 10
PV = –1200
PMT = 40
FV = 1000
CPT
I = 1.797
yield-to-maturity = 1.797 × 2 = 3.594%
11. Price today Price in one year
N = 18 N = 17
I = 10 I=9
PMT = 80 PMT = 80
FV = 1000 FV = 1000
CPT CPT
PV = –835.97 PV = –914.56
Holding Period Return = ($80 + $914.56 – $835.97)/$835.97 = 18.97%

13. Yield to Maturity

N = 20
PV = –1098.62
PMT = 90
FV = 1000
CPT
I = 7.996%

15. N = 120
PV = –1065
PMT = 30
FV = 1000
CPT
I = 2.811
yield-to-maturity = 2.811 × 4 = 11.244%

17. A. Price Yield to Call

N = 40 N = 10
I = 5.25 PV = –875.79
PMT = 45 PMT = 45
FV = 1000 FV = 1050
CPT CPT
PV = –875.79 I = 6.61% × 2 = 13.22%
B. Price Yield to Call
N = 20 N=5
I = 7.5 PV = –1050.97

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 11

 PMT = 80 PMT = 80
FV = 1000 FV = 1050
CPT CPT
PV = –1050.97 I = 7.60%
Current yield A = $90/$875.79 = 10.28%
Current yield B = $80/$1050.97 = 7.61%
Higher current yield A
Higher YTM A
Higher YTC A

19. Price
N = 10
I=9
PMT = 0
FV = 1000
CPT
PV = –422.41
The price is $422.4

21. Expected Yield

N=3
PV = –800
PMT = 80
FV = 950
CPT
I = 15.38%
Accrued interest = $80 × 9/12 = $60.00, Capital gain = $150
HPR = ($60 + $150)/$800 = 26.25%

23. Modified duration  Macaulay duration/(1  Yield)  9.5/1.075  8.84

25. The prices of the bond at yields of 6.5%, 7.0% and 7.5% compounded semiannually are:
N 50 50 50
I 3.25 3.5 3.75
PMT 30 30 30
FV 1000 1000 1000
PV (Price) 938.62 882.72 831.74

938.62  831.74
ED   12.11 years
2  882.72  0.0025

The effective duration is 12.11 years.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 11

27. This question is about bond price volatility. We need to measure the responsiveness of a bond’s price
to a given change in market interest rates. To maximize capital gains, we need to select the bond that
has the maximum price volatility. To do this, first calculate the modified duration of each bond using
the following formula:
Duration in years
Modified duration 
1  Yield-to-maturity
Then calculate the price change with the following formula:
% change in bond price  1  Modified duration  Change in interest rates

a. Bond with duration of 8.46 years with YTM of 7.5%:

8.46
Modified duration   7.87%
1  .075
% change in bond price  1  7.87  0.5%  3.935%
b. Bond with duration of 9.30 years with YTM of 10%:
9.30
Modified duration   8.45%
1  .10
% change in price  1  8.45  0.5%  4.225%
c. Bond with duration of 8.75 years with YTM of 5.75%:
8.75
Modified duration   8.27%
1  .0575
% change in price  1  8.27  0.5%  4.135%
Bond (b) offers the potential for maximum capital appreciation. To maximize gains, this bond should
be selected over the others.
Note: This question can be answered directly by looking at the modified duration. For a given change
in interest rates, the bond with the highest modified duration will offer maximum price appreciation
potential. Bond (b), with the highest modified duration, is the choice for the investor who wishes to
maximize capital gains.

29. The duration and modified duration can be calculated using the IMD software. It gives the precise
duration measure because it avoids the rounding-off errors which are inevitable with manual
calculations. The following answers are computed using a Lotus 1-2-3 worksheet set up to mimic
manual calculations using present value factors from Table B.3. The duration and modified duration
measures using IMD are provided for comparison.
a. Duration and modified duration:
T
[ PV (Ct )  t ]
Duration  
t 1 Pbond
Duration in years
Modified duration 
1  Yield-to-maturity

Bond 1: 13 years, 8.25, priced to yield 7.47%:

Using EXCEL, duration of this bond is 8.74 years.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 11

 8.74
Modified duration   8.13
1  .0747
Using the software, the duration is 8.58 years and the modified duration is 7.97.

Bond 2: 15 years, 7.88, priced to yield 7.60%:

Using EXCEL, duration of this bond is 9.41 years.
9.41
Modified duration   8.75
1  .0760
Using EXCEL the duration is 9.37 years and the modified duration is 8.71.

Bond 3: 20 years, zero-coupon, priced to yield 8.22%:

With a zero-coupon bond, the duration of this bond is the same as its maturity, 20 years.
20.00
Modified duration   18.48
1  .0822

Bond 4: 24 years, 7.5, priced to yield 7.90%:

Using EXCEL, duration of this bond is 11.59 years.
11.59
Modified duration   10.70
1  .0790
Using the software, the duration is 11.56 years and the modified duration is 10.72.
b. When Elliot invests $250,000 in each of the four bonds, the weighted average duration of the
portfolio is:

(1) (2) (3) (4) (5) (6)

Weighted
Bond Amount Bond Duration
Particulars Invested Weight Duration (4)  (5)

Bond 1 13 years, 8.15% $ 250,000 0.25 8.74 2.1850

Bond 2 15 years, 7.875% 250,000 0.25 9.41 2.3525
Bond 3 20 years, 0% 250,000 0.25 20.00 5.0000
Bond 4 24 years, 7.5% 250,000 0.25 11.59 2.8975
$1,000,000 1.00 12.4350

The duration of the portfolio is 12.44 years.

c. When Elliot invests $360,000 each into Bonds 1 and 3, and $140,000 each into Bonds 2 and 4,
the weighted average duration of the bond portfolio is:

(1) (2) (3) (4) (5) (6)

Weighted
Bond Amount Bond Duration
Particulars Invested Weight Duration (4)  (5)

Bond 1 13 years, 8.25% $ 360,000 0.36 8.74 3.1464

Bond 2 15 years, 7.875% 140,000 0.14 9.41 1.3174
Bond 3 20 years, 0% 360,000 0.36 20.00 7.2000
Bond 4 24 years, 7.5% 140,000 0.14 11.59 1.6226

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 11

 $1,000,000 1.00 13.2864

The duration of the portfolio is 13.29 years.

d. Portfolio (c) has a higher duration than portfolio (b). If rates are about to rise, then it is safer to
invest in portfolio (b) because this would be less price-volatile than the other portfolio.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 11