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4 Problem 7-20
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6 Clifford Clark is a recent retiree who is interested in investing some of his savings in corporate bonds. His
7 financial planner has suggested the following bonds:
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9 Ÿ Bond A has a 7% annual coupon, matures in 12 years, and has $1,000 face value.
10 Ÿ Bond B has a 9% annual coupon, matures in 12 years, and has $1,000 face value.
11 Ÿ Bond C has an 11% annual coupon, matures in 12 years, and has $1,000 face value.
12 Each bond has a yield to maturity of 9%.
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14 a. Before calculating the prices of the bonds, indicate whether each bond is trading at a premium, at a discount,
15 or at par.
16 Bond A is selling at a discount because its coupon rate (7%) is less than the going interest rate (YTM = 9%).
17 Bond B is selling at par because its coupon rate (9%) is equal to the going interest rate (YTM = 9%).
18 Bond C is selling at a premium because its coupon rate (11%) is greater than the going interest rate (YTM = 9%).
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20 Work parts b through e with a spreadsheet. You can also work these parts with a calculator to check your
21 spreadsheet answers if you aren't confident of your spreadsheet solution. You must then go on to work
22 part g with the spreadsheet.
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24 b. Calculate the price of each of the three bonds.
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26 Basic Input Data: Bond A Bond B Bond C
27 Years to maturity: 12 12 12
28 Periods per year: 1 1 1
29 Periods to maturity: 12 12 12
30 Coupon rate: 7% 9% 11%
31 Par value: $1,000 $1,000 $1,000
32 Periodic payment: $70 $90 $110
33 Yield to maturity: 9% 9% 9%
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35 VB0 = $856.79 $1,000.00 $1,143.21
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c. Calculate the current yield for each of the three bonds. (Hint: Refer to Footnote 8 for the definition of the current
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yield and to Table 7-1.
38 Current yield = Annual coupon / Price
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40 Bond A Bond B Bond C
41 Current yield = 8.17% 9.00% 9.62%
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43 d. If the yield to maturity for each bond remains at 9%, what will be the price of each bond 1 year from now?
44 What is the expected capital gains yield for each bond? What is the expected total return for each bond?
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46 Basic Input Data: Bond A Bond B Bond C
47 Years to maturity: 11 11 11
48 Periods per year: 1 1 1
49 Periods to maturity: 11 11 11
50 Coupon rate: 7% 9% 11%
51 Par value: $1,000 $1,000 $1,000
52 Periodic payment: $70 $90 $110
53 Yield to maturity: 9% 9% 9%
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55 VB1 = $863.90 $1,000.00 $1,136.10
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57 Expected CG Yield = 0.83% 0.00% -0.62%
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59 Expected Total Return = 9.00% 9.00% 9.00%
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61 e. Mr. Clark is considering another bond, Bond D. It has an 8% semiannual coupon and a $1,000 face value
62 (i.e., it pays a $40 coupon every 6 months). Bond D is scheduled to mature in 9 years and has a price of $1,150.
63 It is also callable in 5 years at a call price of $1,040.
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65 Basic Input Data: Bond D
66 Years to maturity: 9
67 Periods per year: 2
68 Periods to maturity: 18
69 Coupon rate: 8%
70 Par value: $1,000
71 Periodic payment: $40
72 Current Price: $1,150
73 Call Price: $1,040
74 Years until callable: 5
75 Periods until callable: 10
76
77 YTM = 5.83%
78 YTC = 5.26%
79
80 (1) What is the bond's nominal yield to maturity? 5.83%
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82 (2) What is the bond's nominal yield to call? 5.26%
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84 (3) If Mr. Clark were to purchase this bond, would he be more likely to receive the yield to maturity or yield to call?
85 Explain your answer.
86 The bond is selling at a premium, which means that interest rates have declined. If interest rates remain at current
87 levels, then Mr. Clark should expect the bond to be called. Consequently, he would earn the YTC not the YTM.
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89 f. Explain briefly the difference between interest rate (or price) risk and reinvestment rate risk. Which of the
90 following bonds has the most interest rate risk?
91 9% 10% % Chge
92 Ÿ A 5-year bond with a 9% annual coupon. $1,000.00 $962.09 -3.79%
93 Ÿ A 5-year bond with a zero coupon. $649.93 $620.92 -4.46%
94 Ÿ A 10-year bond with a 9% annual coupon. $1,000.00 $938.55 -6.14%
95 Ÿ A 10-year bond with a zero coupon. $422.41 $385.54 -8.73%
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97 Interest rate (price) risk is the risk of a decline in a bond's price due to an increase in interest rates.
98 Reinvestment rate risk is the risk that a decline in interest rates will lead to a decline in income
99 from a bond portfolio.
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101 Ranking the bonds above in order from the most interest rate risk to the least interest rate risk:
102 10-year bond with a zero coupon, 10-year bond with a 9% annual coupon, 5-year bond with a
103 zero coupon, and 5-year bond with a 9% annual coupon.
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105 You can double check this ranking by calculating the prices of each bond at 2 different interest rates, and then
106 determining the percentage change in value. (See calculations above.)
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108 g. Only do this part if you are using a spreadsheet. Calculate the price of each bond (A, B, and C) at the end of each
109 year until maturity, assuming interest rates remain constant. Create a graph showing the time path of each bond's
110 value similar to Figure 7-2.
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112 Years Remaining Until Maturity Bond A Bond B Bond C
113 12 $856.79 $1,000.00 $1,143.21 Time Paths of Bonds
114 11 $863.90 $1,000.00 $1,136.10 Bond Value
115 10 $871.65 $1,000.00 $1,128.35 $1,400.00
116 9 $880.10 $1,000.00 $1,119.90
$1,200.00
117 8 $889.30 $1,000.00 $1,110.70
$1,000.00
118 7 $899.34 $1,000.00 $1,100.66
6 $910.28 $1,000.00 $1,089.72 $800.00
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120 5 $922.21 $1,000.00 $1,077.79 $600.00
121 4 $935.21 $1,000.00 $1,064.79 $400.00
122 3 $949.37 $1,000.00 $1,050.63 $200.00
123 2 $964.82 $1,000.00 $1,035.18 $0.00
124 1 $981.65 $1,000.00 $1,018.35 12 11 10 9 8 7
125 0 $1,000.00 $1,000.00 $1,000.00 Years Remainin
126
127 (1) What is the expected interest yield for each bond in each year?
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129 Years Remaining Until Maturity Bond A Bond B Bond C
130 12 8.17% 9.00% 9.62%
131 11 8.10% 9.00% 9.68%
132 10 8.03% 9.00% 9.75%
133 9 7.95% 9.00% 9.82%
134 8 7.87% 9.00% 9.90%
135 7 7.78% 9.00% 9.99%
136 6 7.69% 9.00% 10.09%
137 5 7.59% 9.00% 10.21%
138 4 7.48% 9.00% 10.33%
139 3 7.37% 9.00% 10.47%
140 2 7.26% 9.00% 10.63%
141 1 7.13% 9.00% 10.80%
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143 (2) What is the expected capital gains yield for each bond in each year?
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145 Years Remaining Until Maturity Bond A Bond B Bond C
146 12 0.83% 0.00% -0.62%
147 11 0.90% 0.00% -0.68%
148 10 0.97% 0.00% -0.75%
149 9 1.05% 0.00% -0.82%
150 8 1.13% 0.00% -0.90%
151 7 1.22% 0.00% -0.99%
152 6 1.31% 0.00% -1.09%
153 5 1.41% 0.00% -1.21%
154 4 1.52% 0.00% -1.33%
155 3 1.63% 0.00% -1.47%
156 2 1.74% 0.00% -1.63%
157 1 1.87% 0.00% -1.80%
158
159 (3) What is the total return for each bond in each year?
160
161 Years Remaining Until Maturity Bond A Bond B Bond C
162 12 9.00% 9.00% 9.00%
163 11 9.00% 9.00% 9.00%
164 10 9.00% 9.00% 9.00%
165 9 9.00% 9.00% 9.00%
166 8 9.00% 9.00% 9.00%
167 7 9.00% 9.00% 9.00%
168 6 9.00% 9.00% 9.00%
169 5 9.00% 9.00% 9.00%
170 4 9.00% 9.00% 9.00%
171 3 9.00% 9.00% 9.00%
172 2 9.00% 9.00% 9.00%
173 1 9.00% 9.00% 9.00%