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Unformatted text preview: Answers to End-of-Chapter Questions Q4-1. What is the relationship between the price of a financial asset and the return that investors require on that asset, holding other factors constant? A4-1. Holding an assets cash flows constant, if investors pay a higher price for the asset, then their return from holding the asset will be lower. In general, asset prices are inversely correlated with returns. Q4-2. Define the following terms commonly used in bond valuation: (a) par value , (b) maturity date , (c) coupon , (d) coupon rate , (e) coupon yield , (f) yield to maturity ( YTM ), and (g) yield curve . A4-2 . The par value is the face value of principal amount that a bond repays when it matures. It is usually $1,000 for corporate bonds. The maturity date indicates when a bonds final payment is due, and it signals the end of the bonds life. The coupon is the dollar amount of interest that a bond pays over a year. The coupon rate equals the coupon divided by the par value. The coupon yield equals the coupon dividend by the market price of the bond. The YTM is the discount rate that equates the present value of a bonds cash flows to its current market price, and it is a measure of the return that investors require on a particular bond. The yield curve is a graph showing how interest rates vary with maturity for a group of bonds having equal risk. Q4-3. Under what circumstances will a bonds coupon rate exceed its coupon yield ? A4-3. This occurs when the bond sells at a premium. Q4-4. What is the difference between a pure discount bond and a bond that trades at a discount? A4-4. A pure discount bond pays no interest. A bond that sells at a discount pays interest at a rate that is below the markets required rate of return. Q4-5. A firm issues a bond at par value . Shortly thereafter, interest rates fall. If you calculated the coupon rate , coupon yield , and yield to maturity for this bond after the decline in interest rates, which of the three values would be highest and which would be lowest? Explain. A4-5. As rates fall the bonds price will rise. This does not affect the coupon rate, but it will lower the coupon yield and the YTM. Because the bond now sells at a premium, there is a built-in capital loss for the investor who paid par value and holds the bond to maturity. Compensating for this loss is the fact that the bonds coupon yield will be greater than the YTM. So in order we have: Coupon rate > coupon yield > YTM Q4-6. Twenty-five years ago, the U.S. government issued thirty-year bonds with a coupon rate of about eight percent. Five years ago, the U.S. government sold ten-year bonds with a coupon rate of about 5 percent. Suppose that the current coupon rate on newly issued five-year Treasury bonds is 2.5 percent. For an investor seeking a low-risk investment maturing in five years, do the bonds issued twenty-five years ago with a much higher coupon rate provide a more attractive return than the new five-year bonds? What about the ten-year bonds issued five years ago?than the new five-year bonds?...
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- Spring '08