BOND MATH CASE

FUNDAMENTALS OF MANAGERIAL FINANCE Fernando Carrillo 1307744 Ricardo Parada 957477 Carlos Villalobos 224408

Bond Math

1.- Dirk Schwartz, an analyst for TwoX Asset Management L.P., is considering investing $1 million in one of three risk-free bonds. All are single-coupon bonds that make a single payment at maturity. Although interest accrues daily, no cash is paid until the bonds mature. Bond A matures in two years and promises an annual interest rate of 9%. Compounding occurs annually; accrued interest is added to the bonds principal at the end of each year. Bond B has a maturity of two years and interest promises an annual rate of 8.85% (4.425% every six months). Compounding occurs semiannually; accrued interest is added to the bonds principal every six months. Bond C matures in two years and promises an annual interest rate of 8.65% (.0237% per day). Compounding occurs daily; accrued interest is added to the bonds principal at the end of every day (assume 365 days/year). A. Calculate the annual yield-to-maturity for each of the bonds. Annual yield-to-maturity is the discount rate that makes the present value of the bonds promised payments equal to the bond price. Equivalently, yield-to-maturity is equal to the bonds internal rate of return. Future Value of the Bond FV= PV * (1 + r)^t Annual Yield to Maturity

First Calculate Future Value of the Bonds

Formula A B C FV= (1,000,000*((1+.09)^1) FV= (1,000,000*((1+.04425)^4) FV= (1,000,000*((1+.000237)^730) Present Value 1,000,000.00 1,000,000.00 1,000,000.00 Years to Maturity 2 2 2 Compounds Annually Semiannually Daily Periods to Annual Effective Maturity Yield Yield 2 4 730 9.00% 8.85% 8.65% 9.0000% 4.4250% 0.0237% Future Value 1,188,100.00 1,189,098.79 1,188,841.74

Then Calculate Annual Yield-to-Maturity

Formula A B C r= ((1,188,100/1,000,000)^(1/2))-1 r= ((1,189,098/1,000,000)^(1/4))-1 r= ((1,188,841/1,000,000)^(1/730))-1 Present Value 1,000,000.00 1,000,000.00 1,000,000.00 Years to Maturity 2 2 2 Future Value 1,188,100.00 1,189,098.79 1,188,841.74 Annual Yield-toMaturity 9.0000% 9.0458% 9.0340%

B. Which of the three bonds should Mr. Schwartz buy? He should buy Bond B because the annual yield-to-maturity of the bond 9.0458% is the highest of the three bonds, which means it is the most profitable one.

2.- Consider the three risk-free bonds described in the table below. The first two are zero-coupon bonds. They make a single (bullet) payment of principal and accrued interest at maturity, but make no cash payments prior to maturity. The third bond is a two-year bond that pays a ten percent coupon annually. All of the bonds have a face (par) value of $100.
Bond Price Bond A Bond B Bond C 89.50 80.00 95.00 Year 1 Cashflow 100.00 10.00 100.00 110.00 Year 2 Cashflow -

A. Calculate the yield-to-maturity for each of the bonds shown in the table above.
Formula A B r= ((100/89.5)^(1/1))-1 r= ((80/100)^(1/2))-1 Present Value 89.50 80.00 Years to Maturity 1 2 Future Value 100.00 100.00 Annual Yield-toMaturity 11.7318% 11.8034%

For Bond C the calculation is different, the book says that given par value, bond value, time to maturity and coupon, the only way to find the yield to maturity is by trial and error. The following is our calculation:
Par Value Bond Value Maturity (years) Coupon rate Annual Payments Formula (10x((1-(1/(1+.13)^2)))/.13)+(100/(1+.12)^2) 100.00 95.00 2 10.00% Bond Price= Cx (1 - (1 / (1 + r) ^ t)) r + F (1 + r)^t

Yield 13.00%

Payment 10.00

Periods 2

Price of the Bond 95.00

B. Of the three bonds, which ones are relatively overpriced and which ones are relatively underpriced. In this case, since it is said that the three bonds are risk-free bonds, then the one that is underpriced is Bond C, because the yield-to-maturity calculated out of the data provided, is much higher than the yields of Bonds A and B. If we used a similar yield to Bonds A and B (11.7% or 11.8%) to calculate the price of Bond C, the the price would be higher, this means that the Bond is underpriced.

C. The bond prices shown in the table above are inconsistent with the law of one price. Describe a portfolio of bonds that would profit from this inconsistency by generating a positive cash flow today and zero cash flows in Year 1 and Year 2. Assume that you can buy or sell any of the bonds at the prices show. We could sell 11 B Bonds and 1 Bond A, with that money you can get to buy 10 C bonds. We get an initial profit of $20 and zero cash flow in years 1 and 2.

Quantity 11 1 10

Bond

Today Year 1 Year 2 $ 880 $ 90 $-$ 1,100

Sell Bond B Sell Bond A Buy Bond C

-$ 100 $ $ 1,100

-$ 950 $ 100

Cash Flow

$ 20

$-

$-

D. Bond D pays $20 at the end of one year and $120 at the end of two years. Assuming that Bond A and Bond B are priced correctly, what Bond D price would satisfy the law of one price?
Par Value Bond Value D Maturity (years) Coupon rate Annual Payments Formula D (20x((1-(1/(1+.118)^2)))/.118)+(100/(1+.118)^2) 100.00 ? 2 20.00% Bond Price= Cx (1 - (1 / (1 + r) ^ t)) r + F (1 + r)^t

Yield 11.80%

Payment 20.00

Periods 2

Price of the Bond 113.89

If we use a yield similar to those of Bond A and Bond B, lets say if we used a yield of 11.80% to price Bond D, then the price of the Bond should be $113.89. So what this means is that for Bond D in order to have a yield-to-maturity of 11.80% which implies that is similar to those of Bond A and Bond B (which are supposed to be correctly priced) the Bond Value should be $113.89.

3. In February 1995, Copiers, Inc. issued one-year zero-coupon bonds with a face value of $1000. The bonds sold for $910 apiece and were rated AA by Standard &Poors. Buyers of the bonds were promised a single $1000 payment at the end of one year. At the time the bonds were issued, one-year Treasury Securities were yielding 6.6%. Assume that market risk premium was 7.2%.

A. What was the yield to maturity at the time of issuance of the Copiers, Inc. bond?
Zero Coupon Bond Future Value Present Value Years to Maturity 1 year T Bill Market Risk Premium AA Rating 1,000.00 910.00 1.00 6.60% 7.20% Annual Yield to Maturity

Formula r= ((1,000/910)^(1/1))-1

Present Value 910.00

Years to Maturity 1

Future Value 1,000.00

Annual Yieldto-Maturity 9.8901%

B. Using the table below, calculate the expected return on the Copiers, Inc. bond when it was issued.
Rating Beta AAA 0.19 AA 0.20 A 0.21 BBB 0.22

The expected return on a security is defined by : R= Rf + B*(Rm Rf) Where: R= Expected return Rf= Risk free rate B= Beta coefficient Rm= Expected Market return rate

Then we have:

premium R 9.22% 9.36% 9.50% 9.64% Rf 6.60% 6.60% 6.60% 6.60%

7.20% Rm 13.80% 13.80% 13.80% 13.80% B 0.19 0.2 0.21 0.22

C. Assume that if Copiers, Inc. defaulted, investors would receive $500 of their original $910 investment and no interest. Given this assumption, what was the markets estimate of the probability that Copiers, Inc. would default on its promised payment at the end of one year?

E[X] = ( Iz + R (1 dz)) 1 zN + z^N

With E[x] equal to the price of the bond, this equation can be solved numerical for z, which than gives the survival probability as p=dz. Given an assumption of what the survival probability is, the equation can be used to calculate E[X] which is the fair price for the bond. z = p/d, I = C / F To get the default probability for the bond, simply subtract the survival probability from 1, default probability = 1 p. The cumulative default probability, or the probability that the bond defaults anytime within the next n coupon periods is 1 p^n. There are several ways to test the formula for the logical consistency. First look at the case where the survival probability is zero so that with z=0 the formula reduces to: E[X] / F = R

This is logical since when default is immanent the price should just equal the recovery amount. In the case where the survival is certain and the risk free rate is zero you have z = 1 and:

E[X] / F = NI + 1 The price here is equal to the total of the coupon payment plus the face value, as you would expect.

Forperiod 1 we have:

E(x) = 915, R = 500/1000 = 0.5, d = 7.2% Solving for p with Excel solver: p= 0.9587, then the probability is 4.42%

D. Suppose that the bonds beta was zero. In an efficient capital market, is it possible for the promised rate to exceed the risk-free rate when beta is zero? Explain thoroughly. (Hint: Make sure that risk is included in your explanation.) No, it is not possible in an efficient capital market for the promised rate to exceed the risk-free rate when beta is zero, because a beta value of zero means that there is no risk on the security, so in an

efficient capital market this would imply that the zero beta security equals a risk-free security, therefore the promised rate and the risk-free rate would be exactly the same. 4. The thable below presents yields for U.S government bonds as of market close on April 30, 1992. The schedule of interest rates versus maturity is referred to a the term structure of interest rates.
Type Bill Bill Note Note Note Bond Maturity 3 Months 1 year 2 years 5 years 10 years 30 years Annual Yieldto-Maturity 3.77% 4.30% 5.42% 7.14% 8.08% 8.04%

A. Plot the government bond yields versus maturity. This is the yield curve.

Yield Curve
9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 3 Months 1 year 2 years 5 years 10 years 30 years Annual Yield-to-Maturity

B. Suppose that the current prices of the 2-year Treasury note and the 30-year Treasury bond are $1000. An investor in these securities would receive semiannual coupon payments starting six months from today, plus $1000 principal repayment at maturity. Using the annual yield-to-maturities provided in the above table, calculate the semiannual coupon payment for the 2-year Treasury note and the 30-year Treasury bond.
Type Note Bond Current Price 1000 1000 Maturity 2 years 30 years Maturity in Years 2.00 30.00 Annual Yieldto-Maturity 5.42% 8.04% Formula (5.42%/2)*1000 (8.04%/2)*1000 Semiannual Coupon Payment 27.100 40.200

C. Suppose that each of the yields in the table above were reduced by 50 basis points,2 but the coupon payments and principal repayment were unchanged. Calculate the new prices for the 2year Treasury note and the 30-year Treasury bond. In general, do changes in yields have a bigger impact on the price of short- term or long-term bonds? Why?

Type Note Bond

Maturity 2 years 30 years

Maturity in Years 2.00 30.00

Annual Yield-toMaturity 4.92% 7.54%

Formula 2 Year 30 Yeras (27.1x((1-(1/(1+.0246)^4)))/.0246)+(1000/(1+.0246)^4) (40.2x((1-(1/(1+.0377)^60)))/.0377)+(1000/(1+.0377)^60)

Yield 2.46% 3.77%

Payment 27.10 40.20

Periods 4 60

Price of the Bond 1,009.41 1,059.11

D. Why are yield curves typically upward sloping? Yields are typically upward sloping because of the risk-return relationship; it is known that when there is a higher risk, there is a higher expected return. On long term investments, it is typically expected as well that since you are leaving your money invested for a longer period of time, it is because you are getting a higher return on the investment. So there has to be an incentive in order to make a long term investment more attractive than a short term investment, and that incentive is a higher yield on the long term. E. What would a downward sloping yield curve imply about the markets expectation for future short-term interest rates? A downward sloping yield curve would imply that the markets expectation for future short-term interest rates is that they will likely to fall. This means that at some point short-term interest rates will tend to get lower. It is important to say as well that historically downward sloping yield curves have preceded economic recessions.