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# case 3 almost done - 3 Suppose TECO has a second bond with...

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3. Suppose TECO has a second bond with 25 years left to maturity (in addition to the one listed in Table 1), which has a coupon rate of 7 3/8 percent and a market price of \$747.48. a) What are (1) the nominal yield and (2) the effective annual YTM on this bond? PV = -\$747.48 PMT = \$36.875 [(\$1,000 * 7.375%) / 2] N = 50 (25 * 2) FV = \$1,000 Now compute: I/Y = 5.09 and multiply by 2 = 10.18% EAR = (1.0509) 2 - 1.0 = 10.44% b) What is the current yield on each of the 25-year bonds? Current Yield = Annual Interest Payment / Price Premium 25-Year Bond : = \$126.25 / \$1220.00 = 10.35% Discount 25-Year Bond : = \$73.75 / \$747.48 = 9.87% c) What is each bond’s expected price on January 1, 1994, and its capital gains yield for 1993, assuming no change in interest rates? (Hint: Remember that the nominal required rate of return on each bond is 10.18 percent.) Premium Bond : I/Y = 5.09 PMT = \$63.125 [(\$1,000 * 12.625%) / 2] N = 48 (24 * 2) FV = \$1,000 Now compute: PV = \$1,218.02 Capital gains yield = \$1,218.02 - \$1,220.00 \$1,220.00 = -0.16% Discount Bond : I/Y = 5.09

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PMT = \$36.875 [(\$1,000 * 7.375%) / 2] N = 48 (24 * 2) FV = \$1,000 Now compute: PV = \$749.88 Capital gains yield = \$749.88 - \$747.48 \$747.48 = 0.32% d) What would happen to the price of each bond over time? (Again, assume constant future interest rates.) Each bond’s price will be headed towards its respective par value of \$1,000 causing, over time, the premium bond’s price to fall while causing the discount bond’s price to rise. e) What is the expected total return (percentage) on each bond during 1993? Premium Bond : Total return = 10.35% + (-0.16%) = 10.19% Discount Bond : Total return = 9.87% + 0.32% = 10.19% f) If you were a tax-paying investor, which bond would you prefer? Why? What impact would this preference have on the prices, hence YTMs, of the two bonds? A tax-paying investor would probably prefer the discount bond because he would only pay taxes on \$73.75 interest payment each year rather than the \$126.25 interest payment on the premium bond. With the discount bond, paying taxes on the capital gains can be put off until the bond matures. Q4)  A.  Interest rate risk is the risk a bond will lose some of its value if  interest rates rise.  Interest rate risk, sometimes called price risk,  increases with maturity and a decreasing coupon.  Reinvestment rate risk  is the risk that the funds received from bonds will have to be reinvested  at rates lower that the yield to maturity.  This type of risk increases with
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case 3 almost done - 3 Suppose TECO has a second bond with...

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