Tutorial 7 Solutions – Bonds

[Readings: Ch17; Ch18]

Q1 [Ch17 – Q2] Identify the three most important determinants of the price of a
bond. Describe the effect of each.

The three factors affecting the price of a bond are coupon, yield, and term to
maturity. The relationship between price and coupon is a direct one - the higher
the coupon, the higher the price. The relationship between price and yield is an
inverse one - the higher the yield the lower the price, all other factors held
constant. The relationship between price and maturity is not so clearly evident.
Price changes resulting from changes in yields will be more pronounced, the
longer the term to maturity.

Q2 [Ch17 – Q3] Given a change in the level of interest rates, discuss how two major
factors will influence the relative change in price for individual bonds.

For a given change in the level of interest rates, two factors that will influence the relative
change in bond prices are the coupon and maturity of the issues. Bonds with longer
maturity and/or lower coupons will have the greatest price changes in response to a
given change in interest rates. Other factors likewise cause differences in price volatility,
including the call features, but these factors are typically much less important.

Q3 [Ch17 – Q7] Why should investors be aware of the trading volume for bonds in
their portfolio?

An investor should be aware of the trading volume for a particular bond because
a lack of sufficient trading volume may make selling the bond in a timely manner
impossible. As a result, prices may vary widely while the investor is trying to
change his position in the bond.

Q4 [Ch17 – Q8] What is the purpose of bond ratings?

Bond ratings provide a very important service in the market for fixed income
securities because they provide the fundamental analysis for thousands of issues.
The rating agencies conduct extensive analyses of the intrinsic characteristics of
the issue to determine the default risk for the investor and inform the market of
the analyses through their ratings.

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Q5 Complete the information requested for each of the following $1,000 face value,
zero-coupon bonds, assuming semi-annual compounding.

Bond Maturity (Years) Yield (%) Price ($)

A 20 12 ?
B ? 8 601
C 9 ? 350

5(a). PV = $1,000 / (1.06)40 = 97.22

The discount rate is 12% annually/2 interest payments per year which equals 6% for 40
semi-annual periods (20 years x 2 interest payments per year)

5(b). PV = $1,000 / (1 + r)n inserting the known items,

$601 = $1,000 / (1.04)n
Solving algebraically or with a financial calculator (PV=-601; FV=1000; r=4;
CPT n) we find that the number of periods equals 12.98 semi-annual periods or
about 6 ½ years for the maturity.

5(c). PV = $1,000 / (1 + r)n inserting the known items,

$350 = $1,000 / (1 + r)18 (use 18 as the number of periods is 2 x 9)
Solving algebraically or with a financial calculator (PV=-350; FV=1000; n=18; CPT
r) we find that the periodic yield equals 6.0% or an annual yield of 12%

Q6 [Ch18 – Q1] Why does the present value (PV) calculation appear to be more
useful for the bond investor than for the common stock investor?

The present value equation is more useful for the bond investor largely because the
bond investor has fewer uncertainties regarding input in the model than does the
common stock investor.
By investing in bonds with relatively no default risk (i.e., government securities) the
investor can value a bond based primarily on expected cash flows (coupon rate and
par value), required return (market yield), and the number of periods in the
investment horizon (maturity date). Even with corporate bonds, default (credit) risk
is incorporated into bond ratings. Examining market data based on time to maturity
and credit rating allows determination of the market interest rate on similar bonds.
Each of these factors can be incorporated into the PV equation.

By contrast, common stocks have no stated maturity date and the valuation process is
predominantly based on estimates of future CFs and discount rate. Although the PV
method can be used for common stock analysis by estimating dividend payments and
change in price over a given time frame, the uncertainties involved are much greater. The
estimation of discount rate is also significantly more difficult and subjective.

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Q7 [Ch18 – Q2] What are the important assumptions made when you calculate the
promised yield to maturity? What are the assumptions when calculating
promised YTC?

The most crucial assumption in both cases that the investor makes is that cash flows will
be received in full and reinvested at the promised yield. This assumption is crucial
because it is implicit in the mathematical equation that solves for promised yield. If the
assumption is not valid, an alternative method must be used, or the calculations will yield
invalid solutions.

Q8 [Ch18 – Q4] We discussed three alternative hypotheses to explain the term

structure of interest rates. Briefly discuss the three hypotheses, and indicate
which one you think best explains the alternative shapes of a yield curve.

The expectations hypothesis imagines a yield curve that reflects what bond investors
expect to earn on successive investments in short-term bonds during the term to maturity
of the long-term bond.

The liquidity preference hypothesis envisions the generally upward-sloping yield curve
owing to the fact that investors prefer the liquidity of short-term loans but will lend long
if the yields are higher.

The segmented market hypothesis contends that the yield curve mirrors the investment
policies of institutional investors who have different maturity preferences.

Student exercise as to which one best explains the alternative shapes of the yield curve;
a viable response is to consider combinations of these three as helpful explanations of
actual yield curve behavior.

Q9 What risks are associated with fixed interest securities, such as bonds? How do
these risks differ from those associated with money market securities?

The cash flows from money market securities and bonds give rise to a number of risks.
These include interest rate risk, default risk, inflation risk, and foreign exchange risk.
However, there are two additional risks that affect bonds but not money market
securities. These are reinvestment risk and call risk.

The price of a bond usually has the assumption that interest or coupon payments can
be reinvested at an interest rate equivalent to the bond yield. Yet, interest rates
change over time and we can only invest the coupons at the available market rates.
While reinvestment risk does not affect zero-coupon bonds or money market
securities, it is a potential problem where bonds pay regular coupon payments. As
each coupon is received it must be reinvested at some unknown future interest rate
and this coupon reinvestment gives rise to reinvestment risk.

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 Call risk refers to the likelihood that the call provision, found in corporate bond issues,
will be exercised. A call provision gives the borrower the right, but not the obligation
to buy back the issue at some specified price and at some time prior to maturity. This
is generally found with bonds paying fixed interest rates. It is important for the
investor because it introduces further uncertainty in terms of bond maturity date,
bonds cash flows, reinvestment risk and interest rate risk. If the bond can be brought
back at a set price, this will tend to occur when interest rates fall because the borrower
can lower borrowing costs by buying back the debt and issuing new debt at a lower
cost. When this occurs the investor is faced with both lower yields and higher prices,
as the price paid by the borrower is generally not the market price but a previously
agreed price written into the bond contract. The investor can be compensated for this
source of risk by means such as a lower initial purchase price or higher coupon
payments.

Q10 Given a one year semi-annual coupon paying bond with face value of
$100,000, coupon of 8% and yield of 10%.
(i) Calculate the duration of the bond.
(ii) Use the duration measure to estimate the change in bond price
expected if the yield increases to 10.5%. Calculate the actual price
change and the error in the estimation.
(iii)
i.
CF PV t Value Weighting
Coupon 1 4000 3809.52 1 0.0388
Coupon2 + 104000 94331.07 2 0.9612
Principal

Bond Price = 98,140.59

Duration = 1 x 0.0388 + 2 x 0.9612 = 1.9612
Macaulay duration 1.9612
modified duration    1.8678
YTM 0.10
1 1
m 2

ii. The change in the yield: 0.0525-0.05 = 0.0025

Estimated price reduction = $98,140.59 x 0.0025 x -1.8678 = -458.27

price at 10% = 98,140.59

price at 10.5% = 97,683.94
actual price reduction = –456.65
error = 1.62