Problem set 2

Topic: Bond Valuation

1. A $1000 par value bond has the following features: a coupon of 8% paid semi
annually and maturing in ten years. What is the bond price if comparable bonds
yield (in terms of APR) 8%? 10%? Why are prices different @ 8% and 10%
YTM?
1) FV 1000 1000
  Coupon rate 4% 4%
  Maturity 20 20
  Req Rate 4% 5%
₹
  PV ₹ 1,000.00 875.38

The prices are different because the price of a bond is inversely proportional to the YTM.
Greater YTM means greater returns and hence also a greater discount rate which means
bond with 10% YTM will be discounted more hence the low price.
2. Terminator Bug, Inc. just sold an issue of 30-year bonds for $1,107.20. Investors
require a rate of return on these bonds of 7.75% PA compounded HY. The bonds
pay interest semiannually. What is the coupon rate of the bonds?
2)      
    PV 1107.2
    Maturity 60
    Req Rate 3.875%
    FV 1000
Coupon
    Amount ₹ 43.38
      8.68%
Coupon rate is the rate of interest paid by bond issuers on the bond's face value
3. Zero Sword has a $1,000 par value bond that is currently selling for $1,300. It has
an annual coupon rate of 7%, paid semiannually, and has nine years remaining
until maturity. What is the annual yield to maturity on the bond?
3)      
    PV 1300
    Coupon Rate 3.50%
    Maturity 18
    FV 1000
Semi Annual
    YTM 1.57%
    Annual YTM 3.15%

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 4. A company has two bonds outstanding. The first maturing in 5 years with a
coupon of 8.25% and the second in ten years bears a coupon of 8.25%. What is
the price of these two bonds? Why are they different? Assume YTM as 10% and
FV as $1000.
4)      
  Maturity 5 10
  Coupon Rate 8.25% 8.25%
  YTM 10% 10%
  FV 1000 1000
₹
  PV ₹ 933.66 892.47
The price of the bonds are different because they have different maturity period.
Hence the bond with greater maturity period will be discounted more times than
with bond with lower maturity period. Therefore the price of bond with longer
maturity is smaller than bond with low maturity period.

5. Consider the two following bonds:

Assume you own both the bonds A and B, if rates are likely to rise on which bond
will you lose more?

bond coupon Maturity years

A 8% 10
B 14% 10

If you own both the bonds X and Y, if rates are likely to fall on which bond will
you gain less?

bond coupon Maturity years

X 18% 10
Y 18% 15
ANS-a) BOND A because it has a longer average life and bonds with longer duration are
more sensitive to a change in interest. Thus an increase in interest will affect(bring down)
the price of bond A more.
b) BOND X because it has a shorter maturity period and is thus less sensitive to
change in interest. Thus an fall in interest rates will affect(increase) the the price of bond
X less than bond Y.
6. Which of the following bonds is the most interest rate sensitive bond?

bond coupon Maturity years

A 8% 10
B 12% 10
C 8% 5
ANS- BOND A is the most sensitive to interest rate because
 It has a longer maturity period than C

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  It has a longer average life than B even though it has the same maturity as B

7. What is the duration of a two-year bond that pays an annual coupon of 10% and
has a current YTM of 12%? Use $1000 as the face value.
FV 1000  
PMT 100  
Coupon 10%  
YTM 12%  
($966.20
PV )  
1.90759 (DURATION(DATE(2000,1,1),DATE(2002,1,1),coupon,YTM,
Duration 1 1))
8. Yankee Inc. has sold a security to raise new funds. Unlike ordinary bonds, it pays
no par value/face value at the end of its life. It only pays coupons every year as
follows: $100(1 + 0.05) at the end of year one, $100(1 + 0.05) 2 at the end of year
two, and so on. This security lasts for 4 years (i.e., makes 4 payments). The
current interest rate is 5% for all maturities. What is the price today of this new
security? What is the Mac duration of this bond?
PV of
8) Time CF CF Weight t * Weight
0.82270
  1 105 100 2 0.822702475
0.82270
  2 110.25 100 2 1.64540495
0.82270
  3 115.7625 100 2 2.468107424
0.82270
  4 121.550625 100 2 3.290809899
      400   8.227024748
           
    MAC Duration= 2.5    

9. Find the change in bond prices as predicted by duration when rates are likely to
change by 1.5%.
YTM BP Coupon Term Duration
10% 100 10% 20 9.36 yrs
when YTM=
9) BP 100   11.5%  
  Coupon Rate 10%   BP = ₹ 88.44
  Maturity 20   dP = ₹ -11.56
  YTM 10%   % change 11.56472379
  Duration 9.36   when YTM =  

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 8.5%
  Modi Duration 8.5091   BP = ₹ 114.20
  Rate Change 1.50%   dP = ₹ 14.20
  As per Dur -12.76363636   % change 14.19500491

10. Suppose that you purchase a bond that matures in five years and pays a 13.76%
coupon. The bond is priced to yield 10%. What is the duration of the bond? Is it
equal to five years? What will be the rate of return earned by you if interest rates
rise to 11% next year and stays there for the remaining period of your investment
horizon (the total length of time that an investor expects to hold a security).
10) Time CF PV of CF Weight t * Weight
0.10996036
  1 137.6 125.0909 3 0.109960363
0.09996396
  2 137.6 113.719 6 0.199927933
0.09087633
  3 137.6 103.3809 3 0.272628999
0.08261484
  4 137.6 93.98265 8 0.330459393
0.62092132
  5 1137.6 706.3601 3 3.104606615
      1142.534   4.017583304
           
           
Mduratio 3.06282092
  BP ₹ -114.25 n 8  
-
110.753982
  FV 100 new Bp 5  
  Coupon Rate 13.76% new YTM 10.34%  
  Maturity 4      
  YTM 10.000%      

11. A 6% 5-year coupon paying bond with a par value of $1000 is trading at an YTM
of 9%. What is the modified duration of the bond?

a. If the YTM changes by 50 bp what will be the actual change in the bond
price? What will be the change in the bond price as per MD rule? What is
the percentage error?
b. If the YTM changes by 250 bp what will be the actual change in the bond
price? What will be the change in the bond price as per MD rule? What is
the percentage error?

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 Compute the changes for both increase and decrease in rates, tabulate your results,
and explore the reasons.

12. Liz owns a portfolio of four bonds given below:

Duration Investment
R 4.5 yrs 1850
S 3.0 1600
T 3.5 1450
V 2.8 2300
What is the duration of Liz’s bond portfolio?
investmen
12)   duration t weight t*weight
0.25694
  R 4.5 1850 4 1.156248
0.22222
  S 3 1600 2 0.666666
0.20138
  T 3.5 1450 9 0.7048615
0.31944
  V 2.8 2300 4 0.8944432
      7200 duration 3.4222187

13. AllSeason Furniture, Inc. issued an 8 percent 15-year bond five years ago. The
bond is selling now for $1,232. Given that the bond’s face value is 1,000 and that
the coupon payments are made annually, what is the AllSeason’s bondholders’
expected return on the bond?
13) pv 1232
  coupon rate 8%
  maturity 10

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  fv 1000
  req rate 5.00%

14. Thalin Inc. has decided to extend its current product line. To finance the project,
the firm is considering issuing a 10-year, 1000 face value bond. Two years ago
the firm issued a 12-year, 1000 face value, 10% coupon bond to finance a similar
project. The current market price of the bond is 1064.5. At what rate should the
firm issue the new bond?
14) Maturity 10
  FV 1000
  PV 1064.5
  Coupon Rate 10%
  YTM 9.00%

Note: bp stands for 1 basis point defined as one-hundredth of 1.00%; YTM is

Yield to maturity; MD is modified duration; APR is Annual Percentage rate

Answers
Q. No Answer Q. No Answer
1 1000 & 875.38 8 400 & 2.5
2 5.22% 9 When rates rise:
actual change = 14.2%
As per Dur rule= 12.76%
When rates decline:
actual change = 11.56%
As per Dur rule = 12.76%
3 3.15% (APR) 10 10.93%
4 933.66 & 892.47 11
5 A, X 12 3.42
6 A 13 5%
7 1.91 yrs 14 9%