Session 5-Solutions

Session 5-Solutions - P = [.40($933.33) + .60($1,150)] /...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
Session 5 – Solutions 20-4. The price of the bond today is the present value of the expected price in one year. The bond will be called whenever the price of the bond is greater than the call price of $1,150. First, we need to find the expected price in one year. If interest rates increase next year, the price of the bond will be the present value of the perpetual interest payments, plus the interest payment made in one year, so: P 1 = ($100 / .12) + $100 P 1 = $933.33 This is lower than the call price, so the bond will not be called. If the interest rates fall next year, the price of the bond will be: P 1 = ($100 / .07) + $100 P 1 = $1,528.57 This is greater than the call price, so the bond will be called. The present value of the expected value of the bond price in one year is:
Background image of page 1
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: P = [.40($933.33) + .60($1,150)] / 1.10 P = $966.67 20-10. In general, this is not likely to happen, although it can (and did). The reason that this bond has a negative YTM is that it is a callable U.S. Treasury bond. Market participants know this. Given the high coupon rate of the bond, it is extremely likely to be called, which means the bondholder will not receive all the cash flows promised. A better measure of the return on a callable bond is the yield to call (YTC). The YTC calculation is the basically the same as the YTM calculation, but the number of periods is the number of periods until the call date. If the YTC were calculated on this bond, it would be positive....
View Full Document

This note was uploaded on 02/14/2011 for the course FINANCE 620 taught by Professor Halstead during the Fall '09 term at UMBC.

Ask a homework question - tutors are online