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Attribution Non-Commercial (BY-NC)

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The bonds will pay a coupon rate of 10% and will mature in 6 years. The face value of the bonds is $1,000; interest is paid semi-annually. The market rate of interest is currently 8% for similar bonds. a. What is the fair price for an investor to pay for one of these bonds? b. If you pay the current price of $1,100 for a bond, what will be your yield-to-maturity? Answer to Question #1 Fair Price of the Bond: Since the interest is payable semi-annually, we need to state everything in semi-annual terms. Number of periods: The bonds have a 6-year maturity, so there will be 12 interest payments (at 6-month intervals). Interest payments: The bonds will pay interest of $100 per year (i.e., 10% * $1,000), or $50 every six months. Required rate: The required rate of return is the market rate of 8%. Therefore, the required rate is 4% semi-annually. Using 4% as the discount rate and 12 semi-annual periods, we take the present value of the interest payments and face value: Periods Cash flow x PVF = PVB (1-12) $ 50.00 x 9.3851 = 469.25 ( 12 ) 1,000.00 x 0.6246 = 624.60 Fair Value = $1,093.85 Yield-to-maturity (or YTM): The fair value (i.e., the present value of the benefits, or PVB) is less than the price (i.e., present value of the costs, or PVC) of the bond, so we know that the YTM is less than the semi-annual market rate of 4% (or 8% annual rate). Lets choose a number lower than 4% and conduct a test to see if we will earn more or less than, say, 3%. Its a trial-and-error technique, so we can choose any number lower than 4% to conduct the test. Since the fair price of $1,093.85 is close to the current price of $1,100, we shouldnt have to go far from 4%. Using the present value factors for 3%: Periods Cash flow x PVF = PVB (1-12) $ 50.00 x 9.9540 = 497.70 ( 12 ) 1,000.00 x 0.7014 = 701.38 Fair Value = $1,199.08 This is more than the price of $1,100; in other words, the PVB is greater than the PVC. So we know that the YTM is greater than 3%. We now have our range: the YTM is between 3% and 4% (semi-annual return), as shown below. We can set up a proportion and interpolate to find the YTM. When we used 3% as our discount rate, we calculated the fair price to be $1,199.08. When we used 4% as our discount rate, we calculated the fair price to be $1,093.85. Between these numbers is the YTM. The YTM will give us a fair price exactly equal to the current price of $1,100. 3% YTM 4% 1,199.08 1,100.00 1,093.85

In each column, we are going to take the distance between the top two numbers and the distance between the outside two numbers. The distance between 3% and the YTM in the left-hand column is an unknown value called x. 3% 1,199.08 (distance on top = x%) (distance on top = 99.08) YTM 1,100.00 (outside distance = 1%) (outside distance = 105.23) 4% 1,093.85 The proportion is: X is to 1% as $99.08 is to $105.23, or X / 1% = 99.08 / 105.23; solving: X = 0.94%. The YTM is 0.94% away from 3%. Therefore, the yield-to-maturity = 3.94% semi-annually or 7.88% annually (a reasonable rounding error is acceptable)

Question #2 You have a chance to buy a BB-rated bond that has a face value of $1,000. The bond has a 5% coupon rate of interest and matures in four years. Interest is paid semi-annually. The market rate of interest is currently 6% per year for similar bonds. a. How much should you be willing to pay for the bonds? b. If you pay the current price of $950 for a bond, what will be your yield-to-maturity? Answer to Question #2 Fair Price of the Bond: Since the interest is payable semi-annually, we need to state everything in semi-annual terms. Number of periods: The bonds have a 4-year maturity, so there will be 8 interest payments (at 6-month intervals). Interest payments: The bonds will pay interest of $50 per year (i.e., 5% * $1,000), or $25 every six months. Required rate: The required rate of return is the market rate of 6%. Therefore, the required rate is 3% semi-annually. Fair Value: Using 3% as the discount rate and 8 semi-annual periods: Periods Cash flow x PVF = PVB (1-8) $ 25.00 x 7.0197 = 175.49 ( 8) 1,000.00 x 0.7894 = 789.40 Fair Value = $964.89 Yield-to-maturity (or YTM): The fair value (i.e., the present value of the benefits, or PVB) is more than the price (i.e., present value of the costs, or PVC) of the bond, so we know that the YTM is more than the semi-annual market rate of 3% (or 6% annual rate). Lets choose a number higher than 3% and conduct a test to see if we will earn more or less than, say, 4%. Its a trial-and-error technique, so we can choose any number higher than 3% to conduct the test. Since the fair price of $964.90 is close to the current price of $950, we shouldnt have to go far from 3%. Using the present value factors for 4%: Periods Cash flow x PVF = PVB (1-8) $ 25.00 x 6.7327 = 168.32 ( 8) 1,000.00 x 0.7307 = 730.70 Fair Value = $899.02 This is less than the price of $950; in other words, the PVB is less than the PVC. So we know that the YTM is less than 4%. We now have our range: the YTM is between 3% and 4% (semi-annual return), as shown below. We can set up a proportion and interpolate to find the YTM. When we used 3% as our discount rate, we calculated the fair price to be $964.89. When we used 4% as our discount rate, we calculated the fair price to be $899.02. Between these numbers is the YTM. The YTM will give us a fair price exactly equal to the current price of $950. 3% YTM 4% 964.89 950.00 899.02

In each column, we are going to take the distance between the top two numbers and the distance between the outside two numbers. The distance between 3% and the YTM in the left-hand column is an unknown value called X. 3% 964.89 (distance on top = X%) (distance on top = 14.89) YTM 950.00 (outside distance = 1%) (outside distance =65.87) 4% 899.02 The proportion is: X is to 1% as $14.89 is to $65.87, or X / 1% = 14.89 / 65.87; solving: X = 0.22%. The YTM is 0.22% away from 3%. Therefore, the yield-to-maturity = 3.22% semi-annually or 6.44% annually (a reasonable rounding error is acceptable)

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