Practice Problem Set #5: Bonds

Theoretical and conceptual questions:

(see notes or textbook for solutions)

1. How would you calculate the realized return on a bond for a holding period?
2. Why is it likely that the realized return is different from the bond’s yield to maturity when the
bond was purchased?
3. What is the difference between nominal and real returns?
4. What is the term structure of interest rates and what determines the shape of the yield
curve?
5. What components make up a bond’s yield to maturity?

Practice Problems:
[Note: some of these questions involve solving for yield to maturity (YTM). On an
exam, you will not be asked to solve for YTM using trial and error. However, you
will develop good intuition about bond prices and yields by solving for YTM in
practice problems.]

1. ABC International has issued $1,000 face value bonds that pay coupons
semiannually. The coupon rate is 8% and the bonds have 20 years until maturity.
(a) If you require a YTM of 9% for a bond of this risk, how much would you be willing
to pay?
(b) Assume you still require a YTM of 9%. If the YTM on the bond were 7%, would
you buy the bond? Explain.

2. A bond was issued seven years ago. The bond pays an annual coupon of 10.5%, and
has 28 years left to maturity. The YTM has declined since the bond was issued and
the bond is now trading at a price of $1,151.74.
(a) What is the current YTM?
(b) You buy the bond today, having missed getting this year’s coupon by mere
seconds. You hold the bond for three years, and sell it just after collecting the
coupon that year. You invest the coupons in your ING savings account, which
pays you a 3% APR, compounded annually. At the time of the sale, the bond’s
YTM has increased sharply to 12%. At the end of 3 years, what is your ROR
(annual realized rate of return) from this investment scheme?
(c) Why is the ROR different from the YTM calculated in (a)

3. You have just bought a newly issued $1,000 ten year bond at par. The bond’s coupon
rate is 12% and coupons are paid semi-annually. You intend to hold the bond for 5
years, at which point you believe the YTM will be 11.5%. You believe you will be able
to reinvest the coupons at 14% APR, compounded semiannually.

(a) If all goes according to plan, what will your ROR be at the end of the five years?
 (b) What was the original YTM at purchase and why is the ROR different from the
original YTM at purchase?

4. One year ago, you purchased a newly issued, 20 year Government of Canada bond
that was issued at its par value of $1,000. The coupon rate on this bond is 7% per year
and the coupons are paid annually (you received the first coupon this morning). Today,
the bond is priced to yield 8% and you have just sold it. What was your return over the
past year?