Chapter 6 Solutions

# Chapter 6 Solutions - Chapter 6 Interest Rates and Bond...

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Chapter 6: Interest Rates and Bond Valuation Answers to Concepts Review and Critical Thinking Questions 1. No. As interest rates fluctuate, the value of a Treasury security will fluctuate. Long-term Treasury securities have substantial interest rate risk. 2. All else the same, the Treasury security will have lower coupons because of its lower default risk, so it will have greater interest rate risk. 3. No. If the bid were higher than the ask, the implication would be that a dealer was willing to sell a bond and immediately buy it back at a higher price. How many such transactions would you like to do? 4. Prices and yields move in opposite directions. Since the bid price must be lower, the bid yield must be higher. 5. There are two benefits. First, the company can take advantage of interest rate declines by calling in an issue and replacing it with a lower coupon issue. Second, a company might wish to eliminate a covenant for some reason. Calling the issue does this. The cost to the company is a higher coupon. A put provision is desirable from an investor’s standpoint, so it helps the company by reducing the coupon rate on the bond. The cost to the company is that it may have to buy back the bond at an unattractive price. 6. 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 bond’s 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 par. 7. Yes. Some investors have obligations that are denominated in dollars; i.e., they are nominal. Their primary concern is that an investment provide the needed nominal dollar amounts. Pension funds, for example, often must plan for pension payments many years in the future. If those payments are fixed in dollar terms, then it is the nominal return on an investment that is important. 8. Companies pay to have their bonds rated simply because unrated bonds can be difficult to sell; many large investors are prohibited from investing in unrated issues. 15. a . The bond price is the present value term when valuing the cash flows from a bond; YTM is the interest rate used in discounting the future cash flows (coupon payments and principal) back to their present values. b. If the coupon rate is higher than the required return on a bond, the bond will sell at a premium, since it provides periodic income in the form of coupon payments in excess of that required by investors on other similar bonds. If the coupon rate is lower than the required return on a bond, the bond will sell at a discount, 1

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## This note was uploaded on 10/13/2010 for the course FIN 300 taught by Professor Dicle during the Fall '08 term at Loyola New Orleans.

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Chapter 6 Solutions - Chapter 6 Interest Rates and Bond...

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