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chapter 6 finance - Chapter 6 Solutions hp CHAPTER 6...

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Chapter 6, Solutions hp CHAPTER 6 – Valuing Bonds Questions LG1 1. What does a call provision allow the issuer to do, and why would they do it? A call provision on a bond issue allows the issuer to pay off the bond debt early at a cost of the principal plus any call premium. Most of the time a bond issuer is called, it is because interest rates have substantially declined in the economy. The issuer calls the existing bonds and issues new bonds at the lower interest rate. This reduces the interest payments the issuer must pay each year. LG2 2. List the differences between the new TIPS and traditional Treasury bonds. Traditional Treasury bonds have a fixed principal and constant payments. Because the principal and coupon rate are fixed, interest rate changes in the economy cause the market price of the bonds to have large fluctuations. On the other hand, the principal of a TIPS increases with the rate of inflation. Similar to a T-bond, the TIPS has a constant coupon rate. However, since the principal of the TIPS increases over time, the interest payment increases over time. This inflation rate adjustment of a TIPS’ principal every six months reduces the amount of downward price change in the price of the bond when interest rates increase. LG2 3. Explain how mortgage-backed securities work. A large amount of home mortgages are purchased and pooled together. The home owners pay interest and principal monthly on their mortgages. Bonds are issued from the pool of mortgages, using the mortgages as collateral. The interest payments and bond principal payments for these mortgage-backed securities (MBS) originate from the mortgage borrowers and flow through the pool of mortgages. As the home owners pay off their mortgages over time, the MBS are also paid. LG3 4. Provide the definitions of a discount bond and a premium bond. Give examples. A discount bond is simply a bond that is selling below its par value. It would be quoted at a price that is less than 100 percent of par, like 99.05. A premium bond is a bond selling above its par value. Its price will be quoted as over 100 percent of par value, like 101.15. A bond becomes a discount bond when market interest rates rise above the bond’s coupon rate. A bond becomes a premium bond when market interest rates fall below the bond’s coupon rate. LG4 5. Describe the differences in interest payments and bond price between a 5 percent coupon bond and a zero coupon bond. 7-1
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Chapter 6, Solutions hp The 5 percent coupon bond pays annual interest of 5 percent of the bond’s par value. For $1,000 par value bond, this would be $50 per year. This interest might be paid in two payments of $25. The price of the coupon bond tends to stay near its par value. The zero coupon bond pays no interest payments. The bondholder earns a return from the increase of the bond’s market price over time. The bond’s price is initially much lower than its par value. When the zero coupon bond finally matures, the par value is paid.
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