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 25year bonds?
Current Yield = Annual Interest Payment / Price
Premium 25Year Bond
:
= $126.25 / $1220.00
= 10.35%
Discount 25Year 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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View Full DocumentPMT = $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 taxpaying investor, which bond would you prefer? Why? What
impact would this preference have on the prices, hence YTMs, of the two bonds?
A taxpaying 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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 Spring '08
 Qayyum
 Interest

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