A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46

G 2/1/2007

Chapter 5. Tool Kit for Bonds, Bond Valuation, and Interest Rates
The value of any financial asset is the present value of the asset's expected future cash flows. The key inputs are (1) the expected cash flows and (2) the appropriate discount rate, given the bond's risk, maturity, and other characteristics. The model developed here analyzes bonds in various ways.

BOND VALUATION (Section 5.3)

A bond has a 15-year maturity, a 10% annual coupon, and a $1,000 par value. The required rate of return (or the yield to maturity) on the bond is 10%, given its risk, maturity, liquidity, and other rates in the economy. What is a fair value for the bond, i.e., its market price? First, we list the key features of the bond as "model inputs": Years to Mat: 15 Coupon rate: 10% Annual Pmt: $100 Par value = FV: $1,000 Required return, rd: 10% The easiest way to solve this problem is to use Excel's PV function. Click fx, then financial, then PV. Then fill in the menu items as shown in our snapshot in the screen shown just below.

Value of bond =

$1,000.00 Thus, this bond sells at its par value. That situation always exists if the going rate is equal to the coupon rate.

The PV function can only be used if the payments are constant, but that is normally the case for bonds.

47 48 49 50 51 52 53 54 55 56 57 58 59

A B Bond Prices on Actual Dates

Thus far we have evaluated bonds assuming that we are at the beginning of an interest payment period. This is correct for new issues, but it is generally not correct for outstanding bonds. However, Excel has several date and time functions, and a bond valuation function that uses the calendar, so we can get exact valuations on any given date. Here is the data for MicroDrive's bond as of the day it was issued.

Settlement date (day on which you find bond price) = 1/5/2007 Maturity date = 1/5/2022 Coupon rate = 10.00% Required return, rd = 10.00% Redemption (100 means the bond pays 100% of its 60 face value at maturity) = 100 61 Frequency (# payments per year) = 1 62 Basis (1 is for actual number of days in month and year) 1 63 64 Click on fx on the formula bar (or click Insert and then Function). This gives you the "Insert Function" dialog box. To find 65 a bond's price, use the PRICE function (found in the "Financial" category of the "Insert Function dialog box). The PRICE 66 function returns the price per $100 dollars of face value. 67 68 Using PRICE function with inputs that are cell references: 69 Value of bond based on $100 face value = $100.00 70 Value of bond in dollars based on $1,000 face value = $1,000.00 71 72 Using the PRICE function with inputs that are not cell references: 73 Value of bond based on $100 face value = =PRICE(DATE(2007,1,5),DATE(2022,1,5),10%,10%,100,1,1) 74 Value of bond based on $100 face value = 100.0000 75 Value of bond in dollars based on $1,000 face value = $1,000.00 76 77 78 Interest Rate Changes and Bond Prices 79 80 Suppose the going interest rate changed from 10%, falling to 5% or rising to 15%. How would those changes affect the 81 value of the bond? 82 83 84 We could simply go to the input data section shown above, change the value for r from 10% to 5% and then 15%, and 85 observe the changed values. An alternative is to set up a data table to show the bond's value at a range of rates, i.e., to show 86 the bond's sensitivity to changes in interest rates. This is done below, and the values at 5% and 15% are boldfaced. 87 Bond Value To make the data table, first type the headings, then type the rates in 88 Going rate, r: $1,000 cells A87:A91, and then put the formula =B41 in cell B86, then select 89 0% $2,500.00 the range A86:B912. Then click Data and then Table to get the 90 5% $1,518.98 menu. The input data are in a column, so put the cursor on column 91 10% $1,000.00 and enter C20 the place where the going rate is inputted. Click OK 92 15% $707.63 93 20% $532.45 to complete the operation and get the table. 94 95 We can use the data table to construct a graph that shows the bond's 96 sensitivity to changing rates. 97

A 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149

Interest Rate Sensitivity $3,000 $2,500 $2,000 $1,500 $1,000 $500 $0 0% 5% 10% 15% 20%

BOND YIELDS (Section 5.4)

Yield to Maturity The YTM is defined as the rate of return that will be earned if a bond makes all scheduled payments and is held to maturity. The YTM is the same as the total rate of return discussed in the chapter, and it can also be interpreted as the "promised rate of return," or the return to investors if all promised payments are made. The YTM for a bond that sells at par consists entirely of an interest yield. However, if the bond sells at any price other than its par value, the YTM consists of the interest yield together with a positive or negative capital gains yield. The YTM can be determined by solving the bond value formula for I. However, an easier method for finding it is to use Excel's Rate function. Since the price of a bond is simply the sum of the present values of its cash flows, so we can use the time value of money techniques to solve these problems. Problem: Suppose that you are offered a 14-year, 10% annual coupon, $1,000 par value bond at a price of $1,494.93. What is the Yield to Maturity of the bond? Use the Rate function to solve the problem. Years to Mat: Coupon rate: Annual Pmt: Current price: Par value = FV: 14 10% $100.00 $1,494.93 $1,000.00

Going rate, r =YTM:

5.00%

The yield-to-maturity is the same as the expected rate of return only if (1) the probability of default is zero, and (2) the bond can not be called. If there is any chance of default, then there is a chance some payments may not be made. In this case, the expected rate of return will be less than the promised yield-to-maturity. Finding the Yield to Maturity on Actual Dates Thus far we have evaluated bonds assuming that we are at the beginning of an interest payment period. This is correct for new issues, but it is generally not correct for outstanding bonds. However, Excel has a function that uses the actual calendar when finding yields. Consider the bond above, with 14 years until maturity. Suppose the actual current date is 1/5/2007, so the bond matures on 1/5/2021. Here is the data for the bond. Settlement date (day on which you find bond price) = Maturity date = 01/05/07 01/05/21

A B C D E F G 150 Coupon rate = 10.00% 151 Price = bond price per $100 par value = $149.49 Redemption (100 means the bond pays 100% of its 152 face value at maturity) = 100 153 Frequency (# payments per year) = 1 154 Basis (1 is for actual number of days in month and year) 0 155 156 Using the YIELD function with inputs that are cell references: 157 Yield to maturity = 5.0% 158 159 160 Yield to Call 161 The yield to call is the rate of return investors will receive if their bonds are called. If the issuer has the right to call the 162 bonds, and if interest rates fall, then it would be logical for the issuer to call the bonds and replace them with new bonds 163 that carry a lower coupon. The yield to call (YTC) is found similarly to the YTM. The same formula is used, but years to 164 maturity is replaced with years to call, and the maturity value is replaced with the call price. 165 166 Problem: Suppose you purchase a 15-year, 10% annual coupon, $1,000 par value bond with a call provision after 10 years 167 at a call price of $1,100. One year later, interest rates have fallen from 10% to 5% causing the value of the bond to rise to 168 $1,494.93. What is the bond's YTC? Note that this is the same bond as in the previous question, but now we assume it can 169 be called. 170 171 Use the Rate function to solve the problem. 172 173 Years to call: 9 174 Coupon rate: 10% 175 Annual Pmt: $100.00 Rate = I = YTC = 4.21% 176 Current price: $1,494.93 177 Call price = FV $1,100.00 178 Par value $1,000.00 179 180 This bond's YTM is 5%, but its YTC is only 4.21%. Which would an investor be more likely to actually earn? 181 182 183 This company could call the old bonds, which pay $100 per year, and replace them with bonds that pay somewhere in the 184 vicinity of $50 (or maybe even only $42.10) per year. It would want to save that money, so it would in all likelihood call the 185 bonds. In that case, investors would earn the YTC, so the YTC is the expected return on the bonds. 186 187 Current Yield 188 The current yield is the annual interest payment divided by the bond's current price. The current yield provides 189 information regarding the amount of cash income that a bond will generate in a given year. However, it does not account 190 for any capital gains or losses that will be realized fi the bond is held to maturity or call. 191 192 Problem: What is the current yield on a $1,000 par value, 10% annual coupon bond that is currently selling for 193 $985? 194 195 Simply divide the annual interest payment by the price of the bond. Even if the bond made semiannual payments, we would 196 still use the annual interest. 197 198 Par value $1,000.00 199 Coupon rate: 10% Current Yield = 10.15% 200 Annual Pmt: $100.00 201 Current price: $985.00

A 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223

The current yield provides information on a bond's cash return, but it gives no indication of the bond's total return. To see this, consider a zero coupon bond. Since zeros pay no coupon, the current yield is zero because there is no interest income. However, the zero appreciates through time, and its total return clearly exceeds zero.

CHANGES IN BOND VALUES OVER TIME (Section 5.4)

What happens to a bond price over time? To set up this problem, we will enter the different interest rates, and use the array of cash flows above. The following example operates under the precept that the bond is issued at par ($1,000) in year 0. From this point, the example sets three conditions for interest rates to follow: interest rates stay constant at 10%, interest rates fall to 5%, or interest rates rise to 15%. Then the price of the bond over the fifteen years of its life is determined for each of the scenarios. Suppose interest rates rose to 15% or fell to 5% immediately after the bond was issued, and they remained at the new level for the next 15 years. What would happen to the price of the bond over time? We could set up data tables to get the data for this problem, but instead we simply inserted the PV formula into the following matrix to calculate the value of the bond over time. Note that the formula takes the interest rate from the column heads, and the value of N from the left column. Note that the N = 0 values for the 5% and 15% rates are consistent with the results in the data table above. We can also plot the data, as shown in the graph below.

A 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 N 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

C D Value of Bond in Given Year: 5% 10% 15% $1,519 $1,000 $708 $1,495 $1,000 $714 $1,470 $1,000 $721 $1,443 $1,000 $729 $1,415 $1,000 $738 $1,386 $1,000 $749 $1,355 $1,000 $761 $1,323 $1,000 $776 $1,289 $1,000 $792 $1,254 $1,000 $811 $1,216 $1,000 $832 $1,177 $1,000 $857 $1,136 $1,000 $886 $1,093 $1,000 $919 $1,048 $1,000 $957 $1,000 $1,000 $1,000

Price of Bond Over Time

$1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0

Rate Drops to 5%
Rate Stays at 10% Rate Rises to 15%

10

15

If rates fall, the bond goes to a premium, but it moves toward par as maturity approaches. The reverse hold if rates rise and the bond sells at a discount. If the going rate remains equal to the coupon rate, the bond will continue to sell at par. Note that the above graph assumes that interest rates stay constant after the initial change. That is most unlikely--interest rates fluctuate, and so do the prices of outstanding bonds.

BONDS WITH SEMIANNUAL COUPONS (Section 5.6)

Since most bonds pay interest semiannually, we now look at the valuation of semiannual bonds. We must make three modifications to our original valuation model: (1) divide the coupon payment by 2, (2) multiply the years to maturity by 2, and (3) divide the nominal interest rate by 2. Problem: What is the price of a 15-year, 10% semi-annual coupon, $1,000 par value bond if the nominal rate (the YTM) is 5%? The bond is not callable. Use the Rate function with adjusted data to solve the problem.

A 277 278 279 280 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323 324

C 30 10% $50.00 $1,000.00 2.5%

Periods to maturity = 15*2 = Coupon rate: Semiannual pmt = $100/2 = Current price: Periodic rate = 5%/2 =

PV =

$1,523.26

Note that the bond is now more valuable, because interest payments come in faster.

THE DETERMINANTS OF MARKET INTEREST RATES (Section 5.7)

Quoted market interest rate = rd = r* + IP + DRP + LP + MRP r* = IP = DRP = LP = MRP = Real risk-free rate of interest Inflation premium Default risk premium Liquidity premium Maturity risk premium

THE REAL RISK-FREE RATE OF INTEREST, r* (Section 5.8)

r* = Real risk-free rate of interest r* = Yield on short-term U.S. Treasury Inflation-Protected Security (TIPS) r* = 2.64%

THE INFLATION PREMIUM (IP) (Section 5.9)

Maturity 5 Years 22 Years 5.18% 5.33% 2.50% 2.56% 2.68% 2.77%

Non-indexed U.S. Treasury Bond TIPS Inflation premium

THE NOMINAL, OR QUOTED, RISK-FREE RATE OF INTEREST, rRF (Section 5.10)

Nominal, or quoted, rate = rd = rRF + DRP + LP + MRP

THE DEFAULT RISK PREMIUM (DRP) (Section 5.11)

Bond spreads are the difference between the yield on a bond and the yield on some other bond of the same maturity.

Spread relative to: Yield (1) 5.25% T-Bond (2) AAA (3) BBB (4)

325 Long-term Bonds 326 U.S. Treasury

Source: see comment.

A 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354 355 356 357 358 359 360 361 362 363 364 365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 AAA AA A BBB BB B CCC

B 6.26% 6.42% 6.54% 6.60% 7.80% 8.42% 10.53%

C 1.01% 1.17% 1.29% 1.35% 2.55% 3.17% 5.28%

D 0.16% 0.28% 0.34% 1.54% 2.16% 4.27%

1.20% 1.82% 3.93%

Note: The spreads in Column (2) are found by taking the yields in Column (1) and subtracting the yield on the U.S. Treasury Bond. The spreads in Column (3) are found by taking the yields in Column (1) and subtracting the yield on the AAA bond. The spreads in Column (4) are found by taking the yields in Column (1) and subtracting the yield on the BBB bond. For a bond with good liquidity, its spread relative to a T-bond of similar maturity is a good estmat of the default risk premium.

THE MATURITY RISK PREMIUM (MRP) (Section 5.12)

Bonds are exposed to interest rate risk and reinvestment rate risk. The net effect is the maturity risk premium. Interest Rate Risk Interest Rate Risk is the risk of a decline in a bond's price due to an increase in interest rates. Price sensitivity to interest rates is greater (1) the longer the maturity and (2) the smaller the coupon payment. Thus, if two bonds have the same coupon, the bond with the longer maturity will have more interest rate sensitivity, and if two bonds have the same maturity, the one with the smaller coupon payment will have more interest rate sensitivity. Compare the interest rate risk of two bonds, both of which have a 10% annual coupon and a $1,000 face value. The first bond matures in 1 year, the second in 25 years. Use the PV function, along with a two variable Data Table, to show the bonds' price sensitivity. Coupon rate: 10% Payment $100.00 Par value $1,000.00 Maturity 1 Going rate = r = YTM 10% Value of bond: $1,000.00

Going rate, r $1,000.00 0% 5% 10% 15% 20% 25%

Value of the Bond Under Different Conditions Years to Maturity 1 25 $1,100.00 $3,500.00 $1,047.62 $1,704.70 $1,000.00 $1,000.00 $956.52 $676.79 $916.67 $505.24 $880.00 $402.27

Bond Value ($)

1,800

A 380 381 382 383 384 385 386 387 388 389 390 391 392 393 394 395 396 397 398 399 400 401 402 403
1,800

B
1,600
1,400 1,200 1,000

25-Year Bond

1-Year Bond

800 600
400 200 0 0% 5% 10% 15% 20% 25%

Interest Rate, rd

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Web Extension 5A: Zero Coupon Bonds

Vandenburg Corporation needs to issue $50 million to finance a project, and it has decided to raise the funds by issuing $1,000 par value, zero coupon bonds. The going interest rate on such debt is 6%, and the corporate tax rate is 40%. Find the issue price of Vandenburg's bonds, construct a table to analyze the cash flows attributable to one of the bonds, and determine the after-tax cost of debt for the issue. Then, indicate the total par value of the issue.

This example analyzes the after-tax cost of issuing zero coupon debt.

Table 5A-1 Input Data

Amount needed = Maturity value= Pre-tax market interest rate, rd = Maturity (in years) = Corporate tax rate = Coupon rate = Coupon payment (assuming annual payments) = PV of payments at rd = Issue Price = $50,000,000 $1,000 6% 5 40% 0% $0 $747.26

Analysis:
Years (1) Remaining years (2) Year-end accrued value (3) Interest payment (4) Implied interest deduction on discount (5) Tax savings (6) Cash flow After-tax cost of debt = 0 5 $747.26 1 4 $792.09 $0.00 $44.84 $17.93 $17.93 2 3 $839.62 $0.00 $47.53 $19.01 $19.01 3 2 $890.00 $0.00 $50.38 $20.15 $20.15 4 1 $943.40 $0.00 $53.40 $21.36 $21.36 5 0 $1,000.00 $0.00 $56.60 $22.64 ($977.36)

$747.26 3.60%

Number of $1,000 zeros the company must issue to raise $50 million Face amount of bonds = # bonds x $1,000

= = =

Amount needed/Price per bond 66,911.279 bonds. $66,911,279

Michael C. Ehrhardt

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Web Extension 5C. Tool Kit for Duration

Duration is a measure of risk for bonds. The following example illustrates its calculation. Years to Mat: Coupon rate: Annual Pmt: Par value = FV: Going rate, r: Table 5A-1 Duration t (1) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 CFt (2) $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $90 $1,090 PV of CFt (3) $82.57 $75.75 $69.50 $63.76 $58.49 $53.66 $49.23 $45.17 $41.44 $38.02 $34.88 $32.00 $29.36 $26.93 $24.71 $22.67 $20.80 $19.08 $17.50 $194.49 Sum of t(PV of CFt) = t(PV of CFt) (4) 82.57 151.50 208.49 255.03 292.47 321.98 344.63 361.34 372.95 380.17 383.66 383.98 381.63 377.05 370.63 362.69 353.54 343.43 332.58 3,889.79 20 9.00% $90.0 $1,000 9.00%

9%

9.9501

VB =

$1,000.00

$9,950.11 9.9501

Duration = VB / Sum of t(PV of CFt) =

Consider the amount that would accumulate during the first 10 years, if all coupons are reinvested at the original interest rate of 9%. To do this, first find the amount that would be in the account at 10 years (including the 10-year coupon). Then we find the value of the bond at year 10 based on the payments from 11 and on. Duration of Bond = Target value at year 10 = 9.95011

$10,000.00

Michael C. Ehrhardt

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FV of reinvested coupons at year 10 if no change in rates = PV at year 10 of remaining payments if no change in rates = Total value at year 10 if no change in rates = Value of bonds to be purchased to provide target at 10 years = Number of bonds purchased =

$1,367.36

$1,000.00 $2,367.36

$4,224.11 4.22

Now find the value at year 10 if the market interest rate (shown below) changes immediately after time zero, based on the total number of bonds that were purchased. Interest rate = 9.00%

FV at year 10 = $5,775.89 PV of payments beyond year 10 discounted back to year 10 =

$4,224.11

The total value of the position at time 9.95011 is the value of the reinvested coupon and the current value of the bond. Value of reinvested coupons: Current value of bond: Total value of position = $5,775.89 $4,224.11 $10,000.00

As the table below shows, the total value of a position at a future time equal to the orginal duration will not fall if interest rates change. For example, if rates go up, the value of reinvested coupons increases and the value of the bond at the future date (t=duration) falls, but the net affect is an increase in total value. If rates go down, the value of reinvested coupons goes down, but the future value of the bond goes up, for a net increase in value. Thus, if the desired time horizon is equal to the bond's duration, the value of the position will not fall if interest rates change. Change in Total Value from Original Target $1,402.15 $1,042.90 $744.28 $501.53 $310.54 $167.74 $70.07 $14.90 $0.00 $23.48 $83.77 $179.59

1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12%

Reinvested Coupons $5,775.89 $3,977.42 $4,162.75 $4,358.22 $4,564.36 $4,781.73 $5,010.94 $5,252.60 $5,507.35 $5,775.89 $6,058.93 $6,357.20 $6,671.50

Current Price at t=Duration $4,224.11 $7,424.73 $6,880.15 $6,386.06 $5,937.17 $5,528.81 $5,156.80 $4,817.48 $4,507.55 $4,224.11 $3,964.55 $3,726.57 $3,508.09

Total Value $10,000.00 $11,402.15 $11,042.90 $10,744.28 $10,501.53 $10,310.54 $10,167.74 $10,070.07 $10,014.90 $10,000.00 $10,023.48 $10,083.77 $10,179.59

Michael C. Ehrhardt

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13% 14% 15% 16%

$7,002.63 $7,351.45 $7,718.86 $8,105.78

$3,307.27 $3,122.44 $2,952.12 $2,794.98

$10,309.90 $10,473.89 $10,670.98 $10,900.76

$309.90 $473.89 $670.98 $900.76

Michael C. Ehrhardt

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6/26/2006

xtension 5C. Tool Kit for Duration

ollowing example illustrates its calculation.

uring the first 10 years, if all coupons are reinvested at the original interest hat would be in the account at 10 years (including the 10-year coupon). Then on the payments from 11 and on.

Michael C. Ehrhardt

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erest rate (shown below) changes immediately after time zero, based on the

is the value of the reinvested coupon and the current value of the bond.

position at a future time equal to the orginal duration will not fall if interest value of reinvested coupons increases and the value of the bond at the future increase in total value. If rates go down, the value of reinvested coupons goes p, for a net increase in value. Thus, if the desired time horizon is equal to the not fall if interest rates change.

Michael C. Ehrhardt

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6/26/2006

Web Extension 5D. The Pure Expectations Theory and Estimation of Forward Rates
The shape of the yield curve depends primarily on two key factors: (1) expectations about future inflation and (2) perceptions about the relative riskiness of securities of different maturities. The first factor is the basis for the Pure Expectations Hypothesis. If the relationship between expectations for future inflation and bond yields is controlling, i. e., if no maturity premiums existed, then the pure expectations theory posits that forward interest rates can be predicted by "backing them out of the yield curve." Essentially, under the pure expectations theory, long-term security rates are a weighted average of the yields on all the shorter maturities that make up the longer maturity. This calculation will hold true, providing that the MRP=0 assumption is valid. For instance, if the yield on a 1-year bond is 5% and that on a 2-year bond is 6%, the rate on a 1-year bond one year from now should be 7%, because (1.06)2 = (1.05)(1.07). Generally, r designates the rate, or yield, and our notation involves two subscripts. The first subscript denotes when in the future we expect the yield to exist, and the second denotes the maturity of the security. For instance, the rate expected 3 years from now on a 2-year bond would be denoted by 3r2.

Assuming that expectations theory holds, use the yield information below to back out the following Expected forward rates, in words: Yield on 1-year bond 1 year from now = Yield on 1-year bond 2 years from now = Yield on 1-year bond 3 years from now = Yield on 1-year bond 4 years from now = Yield on 5-year bond 5 years from now = Yield on 10-year bond 10 years from now = Yield on 20-year bond 10 years from now = Yield on 10-year bond 20 years from now = Maturity 1 year 2 year 3 year 4 year 5 year 10 year 20 year 30 year (1+ r2)2 1.1090 1r1 (1+ r3)3 = = = = ( ( Maturity 1 2 3 4 5 10 20 30 (1 + r1) 1.0502 5.60% (1+ r2)2 Yield 5.02% 5.31% 5.48% 5.65% 5.73% 5.68% 6.01% 5.92% x x (1 + 1r1) (1 + 1r1) Symbol: 1r1 2r1 3r1 4r1 5r5 10r10 10r20 20r10

(1 + 2r1)

1.1736 2r1 (1+ r4)4 1.2459 3r1 (1+ r5)5 1.3213 4r1 (1+ r10)10 1.7375 5r5 (1+ r20)20 3.2132 10r10 (1+ r30)30 5.6149 20r10

= = = = = = = = = = = = = = = = =

1.1090 5.82% (1+ r3)3 1.1736 6.16% (1+ r4)4 1.2459 6.05% (1+ r5)5 1.3213 5.63% (1+ r10)10 1.7375 6.34% (1+ r20)20 3.2132 5.74%

(1 + 2r1)

( (

x x

(1 + 3r1) (1 + 3r1)

( (

x x

(1 + 4r1) (1 + 4r1)

( (

x x

(1 + 5r5)5 (1 + 5r5)5

( (

x x

(1 + 10r10)10 (1 + 10r10)10

( (

x x

(1 + 20r10)10 (1 + 20r10)10

The data used to construct the yield curve are readily available, and forward rates can be calculated as

SOLUTIONS TO SELF-TEST QUESTIONS 5a Assume the interest rate on a 1-year T-bond is currently 7% and the rate on a 2-year bond is 9%. If 1-year Treasury yield 2-year Treasury yield Maturity Risk Premium 1-year rate, 1 year from now 7.0% 9.0% 0.0% 11.04%

5b What would the forecast be if the maturity risk premium on the 2-year bond were 0.5% and it was zero 1-year Treasury yield 2-year Treasury yield Maturity Risk Premium 1-year rate, 1 year from now 7.0% 9.0% 0.5% 10.02%

SECTION 5.3
SOLUTIONS TO SELF-TEST 2 A bond that matures in six years has a par value of $1,000, an annual coupon payment of $80, and a market interest rate of 9%. What is its price? Years to Maturity Annual Payment Par value Going rate, rd Value of bond = 6 $80 $1,000 9% $955.14

3 A bond that matures in 18 years has a par value of $1,000, an annual coupon of 10%, and a market interest rate of 7%. What is its price? Years to Maturity Coupon rate Annual Payment Par value Going rate, rd Value of bond = 18 10% $100 $1,000 7% $1,301.77

80, and a market

market interest rate

SECTION 5.4
SOLUTIONS TO SELF-TEST

4 A bond currently sells for $850. It has an eight-year maturity, an annual coupon of $80, and a par value of $1,000. W is its yield to maturity? What is its current yield? Years to Maturity Annual Payment Current price Par value = FV Going rate, rd =YTM: 8 $80.00 $850.00 $1,000.00 10.90%

Annual Payment Current price Current yield:

$80.00 $850.00 9.41%

5 A bond currently sells for $1,250. It pays a $110 annual coupon and has a 20-year maturity, but it can be called in 5 years at $1,110. What are its YTM and its YTC? Is it likely to be called if interest rates don't change? Years to Maturity Annual Payment Current price Par value = FV YTM 20 $110 $1,250 $1,000 8.38% Years to Call Annual Payment Current price Call price YTC

The company will probably call the bond, because the YTC is less than the YTM.

and a par value of $1,000. What

urity, but it can be called in 5 n't change? 5 $110 $1,250 $1,110 6.85%

SECTION 5.5
SOLUTIONS TO SELF-TEST 2a Last year a firm issued 30-year, 8% annual coupon bonds at a par value of $1,000. (1) Suppose that one year later the going rate drops to 6%. What is the new price of the bonds, assuming that they now have 19 years to maturity? Years to Maturity Coupon rate Annual Payment Par value Going rate, rd Value of bond = 29 8% $80 $1,000 6% $1,271.81

2b Suppose instead that one year after issue the going interest rate increases to 10% (rather than 6%). What is the price? Years to Maturity Coupon rate Annual Payment Par value Going rate, rd Value of bond = 29 8% $80 $1,000 10% $812.61

(1) Suppose that one year later ow have 19 years to maturity?

(rather than 6%). What is the

SECTION 5.6
SOLUTIONS TO SELF-TEST

2 A bond has a 25-year maturity, an 8% semiannual coupon, and a face value of $1,000. The going interest rate (r d) is semiannual compounding. What is the bond's price? Coupons per year Annual values Years to Maturity Coupon rate Annual Payment Par value Going rate, rd Value of bond = 25 8% $80 $1,000 6% $1,255.67 2 Semiannual Inputs 50 4% $40 $1,000 3.0% $1,257.30

00. The going interest rate (r d) is 6%, based on

SECTION 5.9
SOLUTIONS TO SELF-TEST

2 The yield on a 15-year TIPS is 3 percent and the yield on a 15-year Treasury bond is 5 percent. What is the inflation premium for a 15-year security

Yield on T-Bond Yield on TIPS Inflation premium

5% 3% 2%

5 percent. What is the inflation

SECTION 5.11
SOLUTIONS TO SELF-TEST

5 A 10-year T-bond has a yield of 6 percent. A corporate bond with a rating of AA has a yield of 4.5 percent. If the cor has excellent liquidty, what is an estimate of the corporate bonds default risk premium?

Yield on T-Bond Yield on corporate bond Default risk premium

6.0% 4.5% 1.5%

a yield of 4.5 percent. If the corporate bond ?

SECTION 5.13
SOLUTIONS TO SELF-TEST QUESTIONS 3 Assume that the real risk-free rate is r* = 3% and the average expected inflation rate is 2.5% for the foreseeable future. The DRP and LP for a bond are each 1%, and the applicable MRP is 2%. What is the bonds yield? r* Inflation Premium Default Risk Premium Liquidity Premium Maturity Risk Premium Yield 3.0% 2.5% 1.0% 1.0% 2.0% 9.5%

s 2.5% for the foreseeable s the bonds yield?