Solutions to Exploration 5.

1
1. 2%
2. 3%
3. The primary difference is likely due to perceptions about the riskiness of each company,
mainly tied to the market’s perception of whether the company will be able to pay the
bond (loan) when it is due. Some difference may be due to the market’s expectation of
economic trends in the short term (first three years) vs. longer term (following two years)
4. $1725.22
5. $1645.40. You lost money.
6. A negative interest rate since you lost money
7. -4.627%
8. Increased because the bond price dropped (and the term is shorter)
9. 5%
10. $822.70
11. $889.00
12. 8.059%
13. a. $889.00, b. $1725.22, c. 2 years, d. -$822.70, e. 1 year
14. -0.52%
15. Your poorly timed transaction means that you put more ‘weight’ on the negative interest
rate than the positive interest rate.
16. It will increase because buying at the end of year 1 is a ‘well-timed’ transaction
17. a. $2667, b. $1725.22, c. 2 years, d. $822.70, e. 1 year, f. 2.75%
18. It will be between the other two dollar-weighted yield rates of -0.52% and 2.75%
19. a. $1778, b. $1725.22, c. 2 years, d. 1.52%
20. 1.52% is between the two previously computed dollar weighted yield rates of -4.1627%
and 2.75%. This makes sense because not buying is worse and not selling is better, and
so the yield is in between.
21. 1.52% since it ignores transaction timing
22. a. $1725.22, b. $1645.40, c. $822.70, d. 889
23. 3.06%
24. 1.52%
25. 1.52%
26. a. 1725.22, b. $1645.40, c. $2468.10, d. $2667.00, e. 3.06%, f. 1.52%

Solutions to exploration 5.2

1. $2000. Each bond is selling for par, so selling price of the bonds equal their redemption
values, or $1000 each
2. Bond 1 is paying 3% nominal, semi-annual compounding and Bond 2 is paying 2%
nominal, semi-annual compounding
3. At 5%, nominal bond price is $944.92. At 1% nominal, bond price is at $1,058.96.
4. The approximate average change in price is about $55 to 59.
5. At 6%, the nominal bond price is $980.87. At 2% nominal, the bond price is $1019.70.
6. The approximate average change in price is about $20.
 7. Bond #1 has a bigger change because it is a longer term bond. Thus, there is more time
for the yield rate to act on the present value of the bond and grow it up to the future
value. Thus, small changes in the yield rate today will have a large impact on the present
value.
8. See the third column of Table 5.6
9. The final payment of $1000 has the largest present value of $970.52. This payment,
while happening the farthest into the future, is much larger than the coupon payments so
still has the largest present value.

Table 5.6. Macaulay duration for Bond #1

Payment date Payment size Present value at a Percentage Product of
(from now; t) 3% nominal yield of total cash time and
rate; 𝑷𝑽(𝑪𝒕 ) flow weighting
(weighting factor;
factor; 𝒕𝑷𝑽(𝑪𝒕 )/
𝑃𝑉(𝐶𝑡 )/ 𝑷𝑽(𝑨𝒍𝒍)
𝑃𝑉(𝐴𝑙𝑙))
0.5 years 15 $14.78 0.01478 0.0074 years
1 year 15 $14.56 0.01456 0.0146 years
1.5 years 15 $14.34 0.01434 0.0215 years
2 years 15 $14.13 0.01413 0.0283 years
2.5 years 15 $13.92 0.01392 0.0348 years
3 years 15 $13.72 0.01372 0.0412 years
3 years 1000 $914.54 0.91454 2.7436 years
Total 𝑃𝑉(𝐴𝑙𝑙) =$1000 100% 2.8913 years
10. See fourth column of Table 5.6
11. The final payment accounts for 91.454% of the total present cash value of the bond
12. The final coupon payment only accounts for 1.372% of the total present cash value of
the bond, because it is a small amount of money being paid the farthest into the future.
13. See fifth column of Table 5.6. The unit is years.
14. MacD=2.8913 years.
15. The final, large, payment is in 3 years. Thus, the average time that the bond pays out
makes sense as a bit less than 3 years (2.8913) to account for the coupon payments
16. Less interest rate risk.
17. The MacD should be smaller because the term of the bond is less (only a one year
bond)
18.

Macaulay duration for Bond #2

Payment date Payment size Present value at a Percentage Product of

(from now; t) 3% nominal yield of total cash time and
rate; 𝑷𝑽(𝑪𝒕 ) flow weighting
(weighting factor;
factor; 𝒕𝑷𝑽(𝑪𝒕 )/
𝑃𝑉(𝐶𝑡 )/ 𝑷𝑽(𝑨𝒍𝒍)
𝑃𝑉(𝐴𝑙𝑙))
0.5 years 20 $19.61 0.01961 0.0098 years
1 year 20 $19.22 0.01922 0.0192 years
1 year 1000 $961.17 0.96117 0.9612 years

Thus, MacD= 0.0098+0.0192+0.9612=0.9902 years.

19. 6+1+2+1 = 10 total cash flows

20. $2000
21. 1.94074 years

Payment date Payment size Present value at a Percentage Product of

(from now; t) 3% nominal yield of total cash time and
rate; 𝑷𝑽(𝑪𝒕 ) flow weighting
(weighting factor;
factor; 𝒕𝑷𝑽(𝑪𝒕 )/
𝑃𝑉(𝐶𝑡 )/ 𝑷𝑽(𝑨𝒍𝒍)
𝑃𝑉(𝐴𝑙𝑙))
0.5 years 15 $14.78 0.00739 0.0037
0.5 years 20 $19.61 0.00981 0.0049
1 year 15 $14.56 0.00728 0.00728
1 year 20 $19.22 0.00961 0.00961
1 year 1000 $961.17 0.4806 0.4806
1.5 years 15 $14.34 0.00717 0.01076
2 years 15 $14.13 0.00707 0.01413
2.5 years 15 $13.92 0.0070 0.0174
3 years 15 $13.72 0.0069 0.0206
3 years 1000 $914.54 0.4573 1.372
Total 𝑃𝑉(𝐴𝑙𝑙) =$2000 100% 1.94074
22. The average time that the payouts from this portfolio are occurring is 1.94074 years from
now.
23. Macaulay duration is a measure of interest rate risk. Lower values of the MacD mean
that the cash flows are coming sooner and, thus, are less impacted by changes to
interest rates. This means that the new portfolio you are considering is less impacted by
changes to the interest rate.
24. The effective duration is 2.948%. That is, for a 1% decrease in yield rates, the bond
price increases 2.948%
25. The effective duration is 0.985%. That is, for a 1% decrease in yield rates, the bond
price increases by 0.985%.
26. Bond #1’s effective duration is larger. This means that the value of bond #1 changes
more than bond #2 if the interest rate changes. This makes sense because Bond #1 has
its redemption payment farther in the future.
27. The effective duration is 1.97%. That is, for a 1% decrease in yield rates, the portfolio
price increases by 1.97%.
Solutions to exploration 5.3
 1. You should be setting money aside to get ready for the fact that you have a large debt
payment due ($1 million!) in two years
2. You will have $969,095 in two years. This isn’t enough to pay the $1 million your
company owes (a disadvantage), due to the low interest rate. However, a bank
investment is probably a reasonably ‘guaranteed’ return.
3. Your company could use the $950,000 to buy 2-year bonds and use the redemption of
those bonds to payback the $1 million debt. The advantage is that the yield rate is
probably higher and so you may be able to get closer to the $1 million you need. Of
course, bonds have more risk than the CD, which is a disadvantage.
4. 2.5978% effective annual rate of return
5. $978,713.80. You will be ~$21,300 short.
6. $970.66 each
7. $970,661.70; You would need to buy 1000 bonds to hit the target. However, you can
only afford ~978 bonds.
8. They will be worth $978,000 in two years. Their current value, however, is less than
$950,000 (the purchase price)
9. The bonds will still be worth $978,000 in two years. Now, however, their current value is
more than $950,000 (the purchase price)
10. If interest rates increase or decrease, it doesn’t matter – you will still have $978,000 in
two years. Of course, you don’t have enough to pay off your debt (you are $22,000
short!)
11. The yield rate is higher and so, potentially, means that we can invest the $950,000 we
have today and get to the $1 miilion we need.
12.
Prices and yield of zero-coupon bonds

Redemption time Yield Price

1-year 2.8% $972.76
2-years 1.5% $970.66
3-years 2.8% $920.49

13. You can buy approximately 976 1-year bonds.

14. You will then have $976,000 on hand one year from now when these bonds payout. This
means that you have to decide what to do with the $976,000 for the next year until the
liability is due to be paid back.
15. You will have $985,760 on hand in this scenario
16. You are running the risk that the yield on one year bonds is lower one year from now
than it is now. Thus, you could still fall short of your target.
17. You won’t have cash on hand from the bond’s redemption (guaranteed payout amount).
18. If you sell the 3-year bonds in two years on the market, you are taking the risk that they
will be valued well at that time. You are hoping that they are yielding a low rate so that
they are worth enough.
19. $949,679.70
20. 2.000281 years. This is (essentially) when your liability is due.
21. $1,003,610
22. $1,003,660
23. $1,003,654
 24.

Buy CD Cash flow 1-year bonds 3-year bonds Duration

matched (2- only only matched
year bonds) (mix of 1
and 3-year
bonds)
Purchase $950,000 $949,305 (978 $949,150 $949,946 $949,683
price bonds) (976 bonds) (1032 bonds)
(current
value)
Value after $969,095 $978,000 $993,568 $1,013,752 $1,003,660
2 years if
bond market
is 1.8% in 2
years
Value after $969,095 $978,000 $1,003,328 $1,003,891 $1,003,610
2 years if
bond market
is 2.8% in 2
years
Value after $969,095 $978,000 $1,013,088 $994,220 $1,003,654
2 years if
bond market
is 3.8% in 2
years
25. The yield on the 1-year and 3-year bonds was better than 2-year bonds which were
available for cost-matching. This won’t always be the case
26. The duration matched is less risky because you have a mix of bonds---some of which
benefit from interest rate decreases and some of which benefit from interest rate
increases.