FOFM - Tutorial 8

Q1. A bond has a quoted price of

$1,080.42. It has a face value of $1,000,
a semi-annual coupon of $30, and a
maturity of five years. What is its current
yield? What is its yield to maturity?
Which is bigger? Why?
Q2. Youre looking at two bonds identical
in every way except for their coupons
and, of course, their prices. Both have
12 years to maturity. The first bond has
a 10 percent coupon rate and sells for
$935.08. The second has a 12 percent
coupon rate. What do you think it would
sell for?
Q3. How does a bond issuer decide on
the appropriate coupon rate to set on its
bonds? Explain the difference between
the coupon rate and the required return
on a bond.
Q4. U.S. Treasury bonds are not rated.
Why? Often, junk bonds are not rated.
Why?
Q5. All else being the same, which has
more interest rate risk, a long-term bond
or a short-term bond? What about a low
coupon bond compared to a high coupon
bond? What about a long-term, high
coupon bond compared to a short-term,
low coupon bond?
Q6. The Faulk Corp. has a 6 percent
coupon bond outstanding. The Gonas
Company has a 14 percent bond
outstanding. Both bonds have 8 years to
maturity, make semiannual payments,
and have a YTM of 10 percent. If interest
rates suddenly rise by 2 percent, what is
the percentage change in the price of
these bonds? What if interest rates
suddenly fall by 2 percent instead? What
does this problem tell you about the
interest rate risk of lower coupon bonds?

Q7. If you were going to issue bonds,

would you prefer to be in a country
where the average inflation rate is 3%
inflation but fluctuates wildly, or in a
country with a higher, 4% expected
inflation rate that is stable (meaning it's
always 4%). Explain.

FOFM - Tutorial 8
Q1. A bond has a quoted price of
$1,080.42. It has a face value of $1,000,
a semi-annual coupon of $30, and a
maturity of five years. What is its current
yield? What is its yield to maturity?
Which is bigger? Why?
Q2. Youre looking at two bonds identical
in every way except for their coupons
and, of course, their prices. Both have
12 years to maturity. The first bond has
a 10 percent coupon rate and sells for
$935.08. The second has a 12 percent
coupon rate. What do you think it would
sell for?
Q3. How does a bond issuer decide on
the appropriate coupon rate to set on its
bonds? Explain the difference between
the coupon rate and the required return
on a bond.
Q4. U.S. Treasury bonds are not rated.
Why? Often, junk bonds are not rated.
Why?
Q5. All else being the same, which has
more interest rate risk, a long-term bond
or a short-term bond? What about a low
coupon bond compared to a high coupon
bond? What about a long-term, high
coupon bond compared to a short-term,
low coupon bond?
Q6. The Faulk Corp. has a 6 percent
coupon bond outstanding. The Gonas
Company has a 14 percent bond
outstanding. Both bonds have 8 years to
maturity, make semiannual payments,
and have a YTM of 10 percent. If interest

rates suddenly rise by 2 percent, what is

the percentage change in the price of
these bonds? What if interest rates
suddenly fall by 2 percent instead? What
does this problem tell you about the
interest rate risk of lower coupon bonds?

Q7. If you were going to issue bonds,

would you prefer to be in a country
where the average inflation rate is 3%
inflation but fluctuates wildly, or in a
country with a higher, 4% expected
inflation rate that is stable (meaning it's
always 4%). Explain.

Solution
Q1.

Q2.

Q3. Bond issuers look at outstanding bonds of similar maturity and risk. The yields on
such bonds are used to establish the coupon rate necessary for a particular issue to
initially sell for par value. Bond issuers also simply ask potential purchasers what
coupon rate would be necessary to attract them. The coupon rate is fixed and simply
determines what the bonds coupon payments will be. The required return is what
investors actually demand on the issue, and it will fluctuate through time. The coupon
rate and required return are equal only if the bond sells for exactly at par.
Q4. Treasury bonds have no credit risk since it is backed by the U.S. government, so a
rating is not necessary. Junk bonds often are not rated because there would be no point
in an issuer paying a rating agency to assign its bonds a low rating (its like paying
someone to kick you!).
Q5. A long-term bond has more interest rate risk compared to a short-term bond, all
else the same. A low coupon bond has more interest rate risk than a high coupon bond,
all else the same. When comparing a high coupon, long-term bond to a low coupon,
short-term bond, we are unsure which has more interest rate risk. Generally, the
maturity of a bond is a more important determinant of the interest rate risk, so the longterm, high coupon bond probably has more interest rate risk. The exception would be if
the maturities are close, and the coupon rates are vastly different.
Q6. Initially, at a YTM of 10 percent, the prices of the two bonds are:
PFaulk = $30(PVIFA5%,16) + $1,000(PVIF5%,16) = $783.24
PGonas = $70(PVIFA5%,16) +$1,000(PVIF5%,16) = $1,216.76
If the YTM rises from 10 percent to 12 percent:
PFaulk = $30(PVIFA6%,16) + $1,000(PVIF6%,16) = $696.82
PGonas = $70(PVIFA6%,16) + $1,000(PVIF6%,16) = $1,101.06
The percentage change in price is calculated as:

Percentage change in price = (New price Original price) / Original price

PFaulk% = ($696.82 783.24) / $783.24 = 0.1103 or 11.03%
PGonas% = ($1,101.06 1,216.76) / $1,216.76 = 0.0951 or 9.51%
If the YTM declines from 10 percent to 8 percent:
PFaulk = $30(PVIFA4%,16) + $1,000(PVIF4%,16) = $883.48
PGonas = $70(PVIFA4%,16) +$1,000(PVIF4%,16) = $1,349.57
PFaulk% = ($883.48 783.24) / $783.24 = +0.1280 or 12.80%
PGonas% = ($1,349.57 1,216.76) / $1,216.76 = +0.1092 or 10.92%
All else the same, the lower the coupon rate on a bond, the greater is its price
sensitivity to changes in interest rates.
Q7. Even though the 4% expected rate is higher, it is stable. As we saw, the inflation
risk isn't really the risk from inflation; it is the risk that results from unexpected changes
in inflation which then can significantly alter the real interest rate, and therefore the real
returns bondholders receive. Because bondholders tend to be risk-averse, they would
want to be compensated for the inflation risk, and since the inflation risk results from
the fluctuations in the rate of inflation, the returns required by bondholders in the
country where the average expected rate is 3% but volatile are likely to be higher than
the required returns on the bonds in the higher but stable inflation country. This
explains, at least partially, why the central banks in many developed countries strive for
inflation stability. Stable prices will lead to lower inflation risk and a more efficient bond
market.