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SOLUTION:
a. With coupons paid once a year:
n i PV FV PMT Result
10 8 ? 100 7 PV =93.29
Price = 93.29
b. With coupons paid twice a year:
n i PV FV PMT Result
20 4 ? 100 3.5 PV =93.20
Price = 93.20
c. Price = 100. When the coupon rate and yield to maturity are the same, the bond sells at par value (i.e. the price
equals the face value of the bond).
2. Assume six months ago the US Treasury yield curve was flat at a rate of 4% per year (with annual
compounding) and you bought a 30-year US Treasury bond. Today it is flat at a rate of 5% per year. What
rate of return did you earn on your initial investment:
a. If the bond was a 4% coupon bond?
b. If the bond was a zero coupon bond?
c. How do your answer change if compounding is semiannual?
SOLUTION:
a and b.
Step 1: Find prices of the bonds six months ago:
n i PV FV PMT Result
Coupon = 4% 30 4 ? 100 4 PV =100
Zero coupon 30 4 ? 100 0 PV =30.83
c.
Step 1: Find prices of the bonds six months ago:
n i PV FV PMT Result
Coupon=4% 60 2 ? 100 2 PV =100
Zero coupon 60 2 ? 100 0 PV =30.48
Instructor’s Manual Chapter 8 Page 112
a. What should be the price of a 2-year coupon bond that pays a 6% coupon rate, assuming coupon
payments are made once a year starting one year from now?
b. Find the missing entry in the table.
c. What should be the yield to maturity of the 2-year coupon bond in Part a?
d. Why are your answers to parts b and c of this question different?
SOLUTION:
a. Present value of first year's cash flow = 6 x .97 = 5.82
Present value of second year's cash flow = 106 x .90 = 95.4
Total present value = 101.22
b. The yield to maturity on a 2-year zero coupon bond with price of 90 and face value of 100 is 5.41%
n i PV FV PMT Result
2 ? -90 100 0 i = 5.41%
Coupon Stripping
4. You would like to create a 2-year synthetic zero-coupon bond. Assume you are aware of the following
information: 1-year zero- coupon bonds are trading for $0.93 per dollar of face value and 2-year 7% coupon
bonds (annual payments) are selling at $985.30 (Face value = $1,000).
a. What are the two cash flows from the 2-year coupon bond?
b. Assume you can purchase the 2-year coupon bond and unbundle the two cash flows and sell them.
i. How much will you receive from the sale of the first payment?
ii. How much do you need to receive from the sale of the 2-year Treasury strip to break even?
SOLUTION:
a. $70 at the end of the first year and $1070 at the end of year 2.
b. i. I would receive .93 x $70 = $65.10 from the sale of the first payment.
ii. To break even, I would need to receive $985.30- $65.10 = $920.20 from the sale of the 2-year strip.
SOLUTION:
Bond 1:
n i PV PMT FV Result
2 5.5% ? 0.06 1 PV= -1.0092
Bond 4:
n i PV PMT FV Result
1 ? -0.95 0 1 i% =5.26%
From Bond 1 and Bond 4, we can get the missing entries for the 2-year zero-coupon bond. We know from bond 1
that:
1.0092 = 0.06/1.055 +1.06/(1.055)2. This is also equal to 0.06/(1+z1) + 1.06/(1+z2)2 where z1 and z2 are the yields
to maturity on one-year zero-coupon and two-year zero-coupon bonds respectively. From bond 4 , we have z1, we
can find z2.
1.0092 – 0.06/1.0526 = 1.06/(1+z2)2, hence z2 = 5.51%.
To get the price P per $1 face value of the 2-year zero-coupon bond, using the same reasoning:
1.0092 – 0.06x0.95 = 1.06xP, hence P = 0.8983
To find the entries for bond 3: first find the price, then the yield to maturity. To find the price, we can use z1 and z2
found earlier:
PV of coupon payment in year 1: 0.07 x 0.95 = 0.0665
PV of coupon + principal payments in year 2: 1.07 x 0.8983 =0.9612
Total present value of bond 3 = 1.0277
n i PMT PV FV Result
2 ? 0.07 -1.0277 1 i = 5.50%
Instructor’s Manual Chapter 8 Page 114
SOLUTION:
a. The callable bond would have a lower price than the non-callable bond to compensate the bondholders for
granting the issuer the right to call the bonds.
b. The convertible bond would have a higher price because it gives the bondholders the right to convert their
bonds into shares of stock.
c. The puttable bond would have a higher price because it gives the bondholders the right to sell their bonds back
to the issuer at par.
d. The bond with the tax-exempt coupon has a higher price because the bondholder is exempted from paying
taxes on the coupons. (Coupons are usually considered and taxed as personal income).
SOLUTION:
If the bond was free of the risk of default, its yield would be 6%.
n i PMT PV FV Result
2 6% 100 ? 1000 PV=-1073.33
The difference between the price of the bond if it were free of default and its actual price (with risk of default) is
the value of a guarantee against default: 1073.3-918 = $155.3
Instructor’s Manual Chapter 8 Page 115
SOLUTION:
a. We have to find the price of the bond if it were only free of the risk of default.
n i PMT PV FV Result
20 5% 55 ? 1000 PV=-1062.3
The bond is traded at par value, hence the difference between the value calculated above and the actual traded
value is the implied value of the call provision: 1062.3 – 1000 = $62.3
Note that the call provision decreases the value of the bond.
b. We have to find the price of the Safeco Corporation:
n i PMT PV FV Result
20 3.5% 55 ? 1000 PV=-1284.2
This bond has the same features as the 5.5% default free callable bond described above, plus an additional feature:
it is convertible into stocks. Hence the implied value of the conversion feature is the difference between the values
of both bonds: 1284.2-1000 = $284.25. Note that the conversion feature increases the value of the bond.
SOLUTION:
The correct answer is e.
Bond prices are inversely proportional to yields hence when yields increase, bond prices fall.
Long-term bonds are more sensitive to yield changes than short-term bonds.