Cornell University
Fall 2010
Economics 3330: Problem Set 3 Solutions
1.
Coupon Renegotiation (Question 20 of Chapter 14 of the text, modified)
A 10-year bond of a firm in severe financial distress has an annual coupon of $80 and sells for
$500.
The firm is currently renegotiating the debt, and it appears that the lenders will allow the
firm to reduce coupon payments on the bond and on the principal to one-half the originally
contracted amount.
The firm can handle these lower payments.
What is the stated and expected
yield to maturity of the bond?
The stated yield to maturity, based on promised payments, equals 19.9%. The expected yield to
maturity is 8%.
These are obtained through standard YTM calculations, with expected payments
substituted for promised payments in the latter.
2.
Rates (Question 12 of Chapter 15 of text)
Suppose that a 1-year zero-coupon bond with face value $100 currently sells at $94.34, while a 2-
year zero sells at $84.99. You are considering the purchase of a 2-year maturity bond making
annual
coupon payments. The face value of the bond is $100, and the coupon rate is 12% per
year.
a. What is the yield to maturity of the 2-year zero? The 2-year coupon bond?
The one-year zero-coupon bond has a yield to maturity of 6%, as shown below:
1
y
1
100
$
34
.
94
$
y
1
= 0.06000 = 6.000%
The yield on the two-year zero is 8.472%, as shown below:
2
2
)
y
1
(
100
$
99
.
84
$
y
2
= 0.08472 = 8.472%
The price of the coupon bond is:
51
.
106
$
)
08472
.
1
(
112
$
06
.
1
12
$
2
Therefore: yield to maturity for the coupon bond = 8.333%
b. What is the forward rate for the second year?
%
00
.
11
1100
.
0
1
06
.
1
)
08472
.
1
(
1
y
1
)
y
1
(
f
2
1
2
2
2
c. If the expectations hypothesis is accepted, what are (1) the expected price of the coupon bond
at the end of the first year and (2) the expected holding-period return on the coupon bond over the
first year?
Expected price
90
.
100
$
11
.
1
112
$

This ** preview** has intentionally

**sections.**

*blurred***to view the full version.**

*Sign up*