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SOLUTIONS MANUAL
CHAPTER 12
PRINCIPLES OF BOND VALUATION AND INVESTMENT
Answers to Text Discussion Questions
1. Why are bonds not necessarily a conservative investment?
12-1. Since bond prices are sensitive to interest rate changes, capital gains or losses are
possible even though interest is paid regularly.
2. How can the market price of a bond be described in terms of present value?
12-2. The price of a bond is the present value of the annuity created by the interest
payments plus the present value of the lump sum of principal returned at maturity.
3. Why does a bond price change when interest rates change?
12-3. Since the bond has a fixed return (the interest promised) based on the bond
contract, the market price of a bond changes to reflect changes in market interest
rates. A bond's price changes to indicate the present value of future cash return,
both interest and principal based on market interest rates (discount factors).
Floating rate bonds are an exception to this principle.
4. Why is current yield not a good indicator of bond returns? (Relate your answer to
maturity considerations.)
12-4. The current yield does not consider the length of time to maturity. A dollar
received this year is worth more than dollars received in future years.
5. Describe how yield to maturity is the same concept as the internal rate of return (or
true yield) on an investment.
12-5. Yield to maturity is the same concept as internal rate of return or true yield
because it is the interest rate (i) at which you can discount the future coupon
payments (Ct) and maturity value (Pn) to arrive at a known current value (V) of
the bond.
6. What is the significance of the yield-to-call calculation?
12-6. If a bond is callable, the yield to call calculation shows what the yield for that
time period would be as compared to yield to maturity (which you may never get
to) or some other length of time.
12-1
12-7. It is assumed that funds are reinvested at the yield from the investment. This is not
necessarily the case. Reinvestment may take place at a higher or lower rate (as
will be discussed in the next chapter).
8. What is the meaning of term structure of interest rates?
12-8. The term structure of interest rates depicts the relationship between maturity and
interest rates. It is sometimes called a yield curve because yields on existing
securities, having maturities anywhere from three months to 30 years, are plotted
on a graph to develop the curve.
9. What does an ascending term structure pattern tend to indicate?
12-9. When the term structure is in an ascending posture (short-term rates are lower
than long-term rates), it is a general signal that interest rates will rise in the future.
10. Explain the general meaning of the expectations hypothesis as it relates to the term
structure of interest rates.
12-10. The hypothesis is that any long-term rate is an average of the expectation of future
short-term rates over the applicable time horizon. Thus, if lenders expect shortterm rates to be continually increasing in the future, they will demand higher
long-term rates. Conversely, if they anticipate short-term rates to be declining,
they will accept lower long-term rates.
11. Explain the liquidity preference theory as it relates to the term structure of interest
rates.
12-11. The shape of the term structure of interest rates tends to be upward sloping more
than any other pattern. This reflects recognition of the fact that long-term maturity
obligations are subject to greater price change movements when interest rates
change. Because of the increased risk of holding longer-term maturities, investors
demand a higher return to hold long-term securities relative to short-term
securities. This is called the liquidity preference theory of interest rates. Since
short-term securities are more easily turned into cash without the risk of large
price changes, investors will pay a higher price and receive a lower yield.
12-2
12-12. When bank loan demand becomes high, banks are likely to partially withdraw
from investments in government securities. Since banks are an important part of
the short-term side of the market, their reduced demand will likely drive up shortterm rates on government securities.
13. Under what circumstances would the yield spread on different classes of debt
obligations tend to be largest?
12-13. The yield spread represents the difference in returns for different classes of bonds
based on ratings. The yield spread tends to be largest when there is a low degree of
confidence in the economy as in the early phases of a recession as investors attempt to
shift out of low grade securities into strong instruments.
14. List the six principles associated with bond-pricing relationships.
12-14. 1.
2.
3.
4.
5.
6.
12-3
12-16. Deep discount bonds have almost no change of being called away even if prices
go up because the value is already far removed from par. Secondly, deep discount
bonds offer the opportunity for higher price increases than high coupon bonds if
interest rates decline.
17. What is a bond swap investment strategy? Explain how it might relate to tax
planning.
12-17. The term "Swap" refers to the procedure of selling out of a given bond position
and immediately buying into another one with similar attributes in an attempt to
improve overall portfolio return or performance.
For tax planning purposes, you might sell a bond on which you have a large loss
and take a reduction against other income. You then take the proceeds from the
sale and reinvest in a bond of equal risk, and you will have increased your total
cash returns because of tax benefits.
PROBLEMS
Bond price
1. Given a 10-year bond that sold for $1,000 with a 13 percent coupon rate, what would
be the price of the bond if interest rates in the marketplace on similar bonds are now 10
percent? Interest is paid semiannually. Assume a 10-year time period.
12-1. PV of $65 semiannually for n = 20 and i = 5%
(Table 12-1 or Appendix D)
12-4
377.00
$1,187.03
Bond price
2. Given a 15-year bond that sold for $1,000 with a 9 percent coupon rate, what would be
the price of the bond if interest rates in the marketplace on similar bonds are now 12
percent? Interest is paid semiannually. Assume a 15-year time period.
12-2. PV of $45 semiannually for n = 30 and i = 6%
(Table 12-1 or Appendix D)
174.00
$793.43
Bond price
3. Given the facts in problem 2, what would be the price if interest rates go down to 8
percent? (Once again, do a semiannual analysis.)
12-3. PV of $45 semiannually for n = 30 and i = 4%
(Table 12-1 or Appendix D)
308.00
$1, 086.14
12-5
$ 401.60
Dollar profit
Percent Profit
Dollar profit $401.60
54.76%
Purchase price $733.40
Current yield
6. What is the current yield of an 8 percent coupon rate bond priced at $877.60?
12.6.
Yield to maturity
7. What is the yield to maturity for the data in problem 6? Assume there are 10 years left
to maturity. It is a $1,000 par value bond. Use the trial-and-error approach with annual
analysis. [Hint: Because the bond is trading for less than par value, you can assume the
interest rate (i) for which you are solving is greater than the coupon rate of 8 percent.]
12.7.
Since the interest rate must be greater than 8%, we will try 9% as a first
approximation.
PV of $80 annually for n = 10, i = 9%
(Table 12-1 or Appendix D)
12-6
12-7
422.00
$935.44
At a 9% discount rate, the answer is $935.44. This is higher than our desired value of
$877.60. In order to bring the value down, we will use a higher interest rate. Lets try
10%.
PV of $80 annually for n = 10, i = 10%
(Table 12-1 or Appendix D)
386.00
$877.60
A 10% discount rate provides the bond price of $877.60. Ten percent is the
yield to maturity.
Yield to maturity
8. What is the yield to maturity for a 10 percent coupon rate bond priced at $1,090.90?
Assume there are 20 years left to maturity. It is a $1,000 par value bond. Use the trialand-error approach with annual analysis. (Hint: Because the bond is trading at a price
above par value, first decide whether your initial calculation should be at an interest rate
above or below the coupon rate.)
12-8. With the bond trading above par value, the discount rate must be below the
coupon rate of 10%. Lets try 9%.
PV of $100 annually for n = 20, i = 9%
(Table 12-1 or Appendix D)
178.00
$1, 090.90
Since 9% provides the desired bond value of $1,090.90, it is the yield to maturity.
Comparison of yields
9. What is the current yield in problem 8? Why is it slightly higher than the yield to
maturity?
12-9. $100/$1,090.90 = 9.17%
It is higher than yield to maturity because it does not take into consideration the
fact that the bond price will decline from $1,090.90 to $1,000 over the next 20
years. This factor lowers the yield to maturity.
12-8
$315.00
$914.13
At an 8% discount rate, the answer is $914.13. This is higher than our desired
value of $839.27. In order to bring the value down, we must use a higher interest
rate. Lets try 9%.
PV of $80 annually for n = 15, i = 9%
(Table 12-1 or Appendix D)
$275.00
$839.27
A 9% discount rate provides the bond price $839.27. 9% is the yield to maturity.
12-9
12-11.
y'
Coupon payment (C t )
$696 $400
$140 $10 $130
11.86%
$1, 096
$1, 096
$140
Yield to call
12. a. Using the facts given in problem 11, what would be the yield to call if the call can
be made in four years at a price of $1,080? Use Formula 123 on page 321.
b. Explain why the answer is lower in part a than in problem 11.
c. Given a call value of $1,080 in four years, is it likely that the bond price would actually
get to $1,160?
12-12. a)
Coupon payment (C t )
y'
$696 $432
$140 $20 $120
10.64%
$1,128
$1,128
$140
12-10
b) Because the bond is callable at $1,080 in four years, the investor must consider
the $80 loss in value over four years from $1,160 to $1,080 ($20 per year). This
substantially reduces yield.
In problem 11, there is also a loss in value from $1,160 to $1,000, but it takes
place over 16 years (only $10 per year). The normal amortization of the premium
over the life of the bond has less of a negative effect on yield.
c) No. The threat of the call will likely keep the price closer to $1,080 (though
with four years to call, a littler higher value than $1,080 may be possible if the
yield on the bond is well above market rates).
Anticipated realized yield
13. a. Using the facts given in problem 11, what would be the anticipated realized yield if
the forecast is that the bond can be sold in three years for $1,280? Use Formula 124 on
page 322. Continue to assume the bond has a 14 percent coupon rate ($140) and a current
price of $1,160.
b. Now break down the anticipated realized yield between current yield and capital
appreciation. (Hint: Compute current yield and subtract this from anticipated realized
yield to determine capital appreciation.)
12-13. a)
Coupon payment (C t )
y 'r
$696 $512
$140 $40 $180
14.90%
$1, 208
$1, 208
$140
12.07%
Price
$1,160
b)
Capital appreciation = Anticipated realized yield Current yield
14.90% 12.07% 2.83%
Current yield =
12-11
$ 247, 680
$ 800, 000
247, 680
$1, 047, 680
Initial value
(Table12 - 4 for12%,30 years,
Gain
Initial value
Gain
Total value
Par value
(100% 30.82%)
New bond price
12-12
Expectations hypothesis
16. The following pattern for one-year Treasury bills is expected over the next four
years:
Year 1 -5%
Year 2 -7%
Year 3-10%
Year 4-11%
a. What return would be necessary to induce an investor to buy a two-year security?
b. What return would be necessary to induce an investor to buy a three-year security?
c. What return would be necessary to induce an investor to buy a four-year security?
d. Diagram the term structure of interest rates for years 1 through 4.
Maturity
12-13
Margin purchase
17. a. Assume an investor purchases a 10-year, $1,000 bond with a coupon rate of 12
percent. The market rate almost immediately falls to 9 percent. What would be the
percentage return on the investment if the buyer borrowed part of the funds with a 25
percent margin requirement? Assume the interest payments on the bond cover the interest
expense on the borrowed funds. (You can use Table 123 in this problem to determine the
new value of the bond.)
b. Assume the same bond in part a is purchased with 25 percent margin, but market rates
go up to 14 percent from 12 percent instead of going down to 9 percent. You can once
again use Table 123 on page 317 to determine the price of the bond. What is the
percentage loss on the cash investment?
12-17. a) The new bond price is $1,195.10 (Table 12-3 for 10 periods with a 12 percent
coupon rate and a 9 percent yield to maturity)
Original bond price
$1,000.00
Increase in value
$ 195.10
Return
$195.10
78.04%
Investment $250.00
$1,000.00
Decrease in value
$ 105.90
Loss on investment
Loss
$105.90
(42.36)%
Investment $250.00
12-14
Bond price
142.00
$1,171.60
c) The deep discount bond is probably the better purchase because a call price of
$1,050 will have no influence on the increase in the bond value. The par value
bond is callable to $1,080 and this may hold down the potential price appreciation
of the bond.
Even if both bonds increase in value as indicated in parts (a) and (b), the deep
discount bond will have the larger percentage gain.
12-15
$801.79
$1,171.60
He was selling bonds for a profit before the required 12-month holding period to
qualify for a long-term capital gain favorable tax rate. That maximum rate is 15
percent as opposed to 35 percent for short-term capital gains.
12-16