FM8e- EOC Sol Ch04

FM8e- EOC Sol Ch04 - Chapter 4 Bond Valuation ANSWERS TO...

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Chapter 4 Bond Valuation ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 4-1 The coupon rate is normally fixed, but it can be indexed so that it floats with some market rate, such as the T-bill rate. Currently (February 2003), new GE bonds would have a coupon rate of about 6% if they had a long maturity, but more like 4½% if they had a short maturity. GE’s currently outstanding bonds would have varying rates, depending on the level of rates at the time they were issued. The current yield is the annual interest divided by the bond’s current price. Since the price changes with changes in the market rate, the current yield also changes over time. Even if the market interest rate remains constant, the current yield will change for a bond that sells at a premium or discount. As a discount bond approaches maturity, its price will rise toward par (baring a strong possibility of default), and with a rising price and constant interest payment, the current yield will decline. The reverse would hold for a bond selling at a premium. See Figure 4-2 for a picture of this. For GE, the current yield would be fairly close to the coupon rate unless the bond in question is an old one that sells at a large premium or discount. The capital gains yield is the change in the bond’s price for the year divided by the beginning price. Interest rates, hence bond prices, move somewhat randomly, so bond prices go up and down creating positive and negative capital gains yields. Also, as discussed above, premium and discount bonds’ prices move toward par over time, so this will create a tendency for such bonds to have positive or negative capital gains yields. The reverse would hold for a bond selling at a premium. The YTM is the discount rate that causes the PV of payments (interest and principal) to equal the current price of the bond. The YTM is also the sum of the current yield and the expected capital gains yield. Note that virtually all bonds pay interest semiannually, and by convention yields are quoted on a nominal basis, not an effective annual rate basis. See the model for YTM calculations. The YTC is found like the yield to maturity, except (1) for years we use the time to call and (2) for the final payment we use the call price. See the model for YTC calculations. Brokers typically quote the yield to call for bonds selling at a premium because, since a premium means that the coupon rate is above the current market rate, the bond is likely to be called. They quote the YTM on par and discount bonds. 4-2 Interest rate risk is the risk that a bond’s price will decline due to an increase n interest rates. Note, though, that if a bond is not callable, then its value will rise if rates fall, even though the value will decline if rates rise. Reinvestment rate risk is the risk that the income produced by a portfolio will decline due to a drop in interest rates as maturing bonds (and coupon payments) are reinvested Answers and Solutions: 4 - 1
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at the new, lower yield. Again, for non-callable bonds, income can
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FM8e- EOC Sol Ch04 - Chapter 4 Bond Valuation ANSWERS TO...

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