Premium Essay

Interest Rates and Bonds

In: Business and Management

Submitted By Morxe
Words 712
Pages 3
Corporate Finance & Asset Markets M1 – Finance & Economics Track

Solutions to Assignment 5: Section 8 - Interest Rates and Bonds
Solutions to Part A: Practice Problems 1. When you are paying out money, you prefer not to pay interest on interest. Thus, you would prefer a low compounding frequency, which is monthly. 2. If the term structure is flat and a 2-year bond with a face value of $1,000 and a 3.5% annual coupon (paid semi-annually) is selling at par, this means that the annual discount rate (compounded semi-annually) is 3.5%, since
4

1, 000 = t=1 1, 000 17.50 + . t (1 + 0.0175) (1 + 0.0175)4

But then it is straightforward to value bonds with any coupon rate and maturity: (a) 10-year bond with a 2% coupon:
20

V

= t=1 10 1, 000 + t (1 + 0.0175) (1 + 0.0175)20 1− 1 (1 + 0.0175)20 + 1, 000 (1 + 0.0175)20

=

10 0.0175 = 874.

(b) 10-year bond with a 6% coupon:
20

V

= t=1 1, 000 30 + t (1 + 0.0175) (1 + 0.175)20 1− 1 (1 + 0.0175)20 + 1, 000 (1 + 0.0175)20

=

30 0.0175 = 1, 209.

3. Expressing the present values bond prices B(0, t), we get   A : 92.70 B : 102.10  C : 111.25

of the coupon bonds in terms of the pure discount = 103 B1 = 6 B1 + 106 B2 = 12 B1 + 12 B2 + 112 B3

Solving sequentially, the solution is B1 = 0.900, B2 = 0.912, and B3 = 0.799. 1

4. (a) The discount factors B1 and B2 implicit in the bonds prices should satisfy:   82.0 = 100 B2 92.5 = 6 B1 + 106 B2  102.5 = 12 B1 + 112 B2 Solving for B1 and B2 from the first two equations, we get B1 = 0.93 and B2 = 0.82. But using these two discount factors to price the third bond gives $103. Thus, there is either an error in the data or a mispricing of bonds prices. (b) We can arbitrage by buying one unit of first and third bonds and selling two units of the second bond. Then we can lock in an initial profit of $.5. The future cash inflows will exactly

Similar Documents

Free Essay

Why Bonds with Different Interest Rates Have Different Maturities

...Why Bonds With Different Maturities Have Different Interest Rates In this paper, I will discuss why bonds with different maturities can have different interest rates. I will do so by explaining the importance of understanding the term structure, as well as the three theories that support the term structure; the expectations theory, the segmented markets theory, and the liquidity premium theory. Term Structure According to Hubbard and O’Brien, the term structure “is the relationship among the interest rates on bonds that are otherwise similar but have different maturities.” Term structure is most commonly analyzed by looking at the Treasury yield curve, which is the relationship of interest rates on Treasury bonds with different maturities on a particular day. Yields generally tend to move in line with maturity, producing an upward sloping yield curve or a “normal yield curve.” Rarely, however, the yields on the long-term treasuries fall below the yields of short-term treasuries. This creates an inverted yield curve. According to a class lecture, six times when the yield curve became inverted, there was an economic recession. Wheelock and Wohar believe that term structure plays an important role in an economy because it “has been found useful for forecasting such variables as output growth, inflation, industrial production, consumption, and recessions.” The Expectations Theory According to Hubbard and O’Brien, the expectations theory “holds that the interest rate on a...

Words: 891 - Pages: 4

Premium Essay

Finance Chapter 6

...Chapter 6 Bonds and their Valuation OVERVIEW This chapter presents a discussion of the key characteristics of bonds, and then uses time value of money concepts to determine bond values. Bonds are one of the most important types of securities to investors, and are a major source of financing for corporations and governments. The value of any financial asset is the present value of the cash flows expected from that asset. Therefore, once the cash flows have been estimated, and a discount rate determined, the value of the financial asset can be calculated. A bond is valued as the present value of the stream of interest payments (an annuity) plus the present value of the par value, which is the principal amount for the bond, and is received by the investor on the bond’s maturity date. Depending on the relationship between the current interest rate and the bond’s coupon rate, a bond can sell at its par value, at a discount, or at a premium. The total rate of return on a bond is comprised of two components: interest yield and capital gains yield. The bond valuation concepts developed earlier in the chapter are used to illustrate interest rate and reinvestment rate risk. In addition, default risk, various types of corporate bonds, bond ratings, and bond markets are discussed. Outline A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. There are four...

Words: 6887 - Pages: 28

Free Essay

Financial Markets

... Instruments   Interest  Rates  and  Valua+on  of  Bonds     DEBT  MARKETS:                            FM2014      5-­‐6.  Debt  Markets:  Structure,  Par+cipants,  Instruments,  Interest  Rates  and  Valua+on  of  Bonds            1   FM:  Objec+ves   A?er  successfully  comple+ng  this  topic,  you  will  be  able  to:     §  Apply  basic  pricing  models  to  evaluate  stocks  and  bonds   §  Describe  the  theoreIcal  determinants  of  the  level  and  term   structure  of  interest  rates     §  Explain  the  concept  of  “yield”  and  its  rela+on  to  “interest  rate”   §  Determine  the  price  of  coupon  and  discount  bonds   §  Compute  the  dura+on  and  convexity  of  a  bond   §  Differen+ate  between  Macaulay  and  modified  dura+on   §  Understand  the  rela+onship  between  dura+on  and  convexity  and   bond  price  vola+lity                          FM2014      5-­‐6.  Debt  Markets:  Structure,  Par+cipants,  Instruments,  Interest  Rates  and  Valua+on  of  Bonds       ...

Words: 4045 - Pages: 17

Premium Essay

Bond Yields

...Bond Yields Interest rates have a big part in determining the yield of a bond. If interest rates rise, the bond will be worth less and if they fall bonds will be worth more. The Yield to Maturity or YTM is the rate of return the lender or borrower will earn if the bond is not sold before its maturity. It can be also referred to as the bond`s yield. In order to be able to calculate the Yield to Maturity, some of the things you would need to know are the current price, the par value, the interest payments, and the maturity date for the bond. A coupon is the stated interest payment made on a bond. The market value will be less than par value if the required rate of return is above the coupon interest rate. Bond will be valued above pay value if the required rate of return is below the coupon interest rate. Also, the lower the coupon rate the greater the interest rate risk. Interest rate risk refers to the risk of fluctuating interest rates. In other words, bond values have an inverse relationship to interest rates. Long-term bonds will have a greater interest rate risk than short-term bonds. Interest rates have a greater impact on long-term bonds because it takes longer for them to mature. Typically, the more you can earn from a bond the more risk there is to it. However, the more risk there is to a bond the more likely either the borrower might default. Bonds have a rating system which gives them a rating based on the likelihood...

Words: 1045 - Pages: 5

Free Essay

Econ Banking Help

...Chapter 6 Rate The Risk and Term Structure of Interest In the previous section, we have generalized our discussion of the influence of various factors on the behavior in interest rate by examining only a particular type of bonds: namely, the 1-year zero coupon bond. However, there are many types of bonds: bonds with different maturity, bonds issued by different parties (i.e. government vs. corporate), etc. As a result, there is a different interest rate for each type of bond. We will look at the behavior of interest rates of two groups of bonds: (1) Bonds with the same features but are issued by different agency. In other words, we want to look at the risk structure of interest rates. (2) Bonds issued by the same agency but have different term to maturity (i.e. life of the bond). In other words, we want to look at the term structure of interest rates. 1. Risk structure of interest rate As we have discussed in the previous section, the (relative) risk level of an asset affects its demands according to the theory of asset demand. The higher the relative risk level, the lower the demand of that asset. According to the theory of asset demand, this leads to an increase in interest rate. In other words, investors need to be compensated with a higher return (in the form of higher interest rate) in order to induce them to hold the assets. There are a number of factors that affect the risk level of a bond. In this section, we will focus on only 3 of them: default risk, liquidity, and tax...

Words: 3232 - Pages: 13

Premium Essay

Fixed Income Security

...Pricing and Trading CHAPTER OUTLINE How are Price and Yield of a Bond Calculated? • Calculating the Fair Price of a Bond • Calculating the Yield on a Treasury Bill • Calculating the Current Yield on a Bond • Calculating the Yield to Maturity on a Bond What is the Term Structure of Interest Rates? • The Real Rate of Return • The Yield Curve What are the Fundamental Bond Pricing Properties? • The Relationship Between Bond Prices and Interest Rates • The Impact of Maturity • The Impact of the Coupon • The Impact of Yield Changes • Duration as a Measure of Bond Price Volatility What are Bond-Switching Strategies? How does Bond Market Trading Work? • Clearing and Settlement • Calculating Accrued Interest © CSI GLOBAL EDUCATION INC. (2011) 7•3 What are Bond Indexes? • Canadian Bond Market Indexes • Global Indexes Summary LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Defi ne present value and the discount rate, and perform calculations relating to the time value of money, bond pricing and yield. 2. Defi ne a real rate of return and a yield curve, and evaluate three theories of interest rate determination. 3. Analyze the impact of fi xed-income pricing properties on bond prices. 4. Explain the rationale for bond switching and describe bond-switching strategies. 5. Summarize the rules and regulations of bond delivery and settlement. 6. Assess the role of bond indexes in the securities industry. THE FIXED-INCOME MARKET IN ACTION ...

Words: 11227 - Pages: 45

Premium Essay

Tax 4001

...various types of bond issues. 3. Describe the accounting valuation for bonds at date of issuance. 4. Apply the methods of bond discount and premium amortization. 5. Describe the accounting for the extinguishment of non-current liabilities. 6. Explain the accounting for long-term notes payable. 7. Describe the accounting for the fair value option 8. Explain the reporting of off-balance-sheet financing arrangements. 9. Indicate how to present and analyze long-term debt. *10. Describe the accounting for a debt restructuring. *Material covered in Appendix I. Overview – Long-term Liabilities (Bonds and Notes Payable) A. What is long-term debt? 1. probable future sacrifices of economic benefit 2. payable in the future, normally beyond one year or operating cycle whichever is longer 3. Examples: bonds payable, long-term notes payable, mortgage notes payable (topics of this chapter), pension liabilities and lease obligations. B. Why issue long-term debt (as opposed to equity)? 1. May be only source of funds 2. Lower cost 3. Interest payments are tax deductible 4. Creditors have no right to vote 5. Takes advantage of financial leverage II. Bonds Payable A. Contract (obligation) called a bond indenture 1. to pay a sum of money 2. at a designated maturity date plus periodic interest 3. at a specified rate on the face value...

Words: 2285 - Pages: 10

Premium Essay

Net Neutrality

...Lecture 4: Bond Market and Bond Valuation GMBA 609: Managerial Finance Dr Anthony Owusu-Ansah aowusu-ansah@gimpa.edu.gh GIMPA Business School October 2014 Dr Owusu-Ansah (GIMPA Business School) Lecture 4: Bonds October 2014 1 / 49 Learning Objectives At the end of this session, you should be able to: De…ne and understand the basic mechanisms of the bond market Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. Describe the legal aspects and the features of di¤erent types of bonds. Apply the basic valuation model to bonds, and describe the impact of required return and time to maturity on bond values. Explain yield to maturity (YTM), its calculation, and the procedure used to value bonds that pay interest semiannually. Dr Owusu-Ansah (GIMPA Business School) Lecture 4: Bonds October 2014 2 / 49 Types of Loans Pure Discount Loan Interest-only Loan Amortized with Fixed Principal payment Amortized with Fixed Payment Dr Owusu-Ansah (GIMPA Business School) Lecture 4: Bonds October 2014 3 / 49 Pure Discount Loans Treasury bills are excellent examples of pure discount loans. The principal amount is repaid at some future date, without any periodic interest payments. Dr Owusu-Ansah (GIMPA Business School) Lecture 4: Bonds October 2014 4 / 49 Pure Discount Loans...con’ t Problem If a T-bill promises to repay $10,000 in 12 months and the market interest rate is 7 percent, how much...

Words: 3151 - Pages: 13

Premium Essay

Ecn 506

...(iv) A plot of the interest rates on default-free government bonds with different terms to maturity is called A) a risk-structure curve. B) a default-free curve. C) an interest-rate curve. D) a yield curve. (v) When yield curves are steeply upward sloping, A) short-term interest rates are above long-term interest rates. B) short-term interest rates are about the same as long-term interest rates. C) medium-term interest rates are above both short-term and long-term interest rates. D) long-term interest rates are above short-term interest rates. (vi) If the expected path of one-year interest rates over the next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent, then the expectations theory predicts that today's interest rate on the five-year bond is A) 4 percent. B) 5 percent. C) 6 percent. D) 7 percent. (vii) According to the liquidity premium theory of the term structure A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time. B) because of the positive term premium, the yield curve will not be observed to be downward sloping. C) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium. D) the interest rate for each maturity bond is determined by supply and demand for that maturity bond. Chapter 5 Q10. Suppose investors...

Words: 582 - Pages: 3

Premium Essay

Solutions to Bonds and Discounts

...Chapter 4 Answers to Concept Review Questions 1. Managers need to understand how bonds and stocks are priced because (1) firms regularly issue stocks and bonds to raise money for investment (2) understanding how securities are priced is helpful when conducting an acquisition or a divestiture, (3) the stock price is an objective signal of how managers are performing, and (4) finance theory teaches that the goal of the manager should be to maximize the firm’s stock price. 5. The coupon rate equals the annual coupon payment divided by par value. The coupon yield equals the annual coupon payment divided by the bond’s market price. 6. A bond sells at a discount when the bond’s coupon rate is lower than the market’s required rate of return on the bond. 11. An issuer benefits from an option to call a bond, because such an option allows the issuer to lock in a more favorable interest rate if rates should fall.. The option to convert bonds into common stock benefits bondholders. Once the stock price rises high enough, the value of the bonds starts to behave like the stock’s value—the prices start to rise. So convertible bonds offer investors some minimal level of return plus a lot of upside potential. 13. The price of a Treasury note quoted as 98:10 is 98 10/32 percent of par value or $983.125. Answers to End-of-Chapter Questions Q4-1. What is the relationship between the price of a financial asset and the return that investors require on that asset, holding...

Words: 2371 - Pages: 10

Premium Essay

Bonds

... a) Bond – is a long term contract under which the borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. Treasury bonds – sometimes referred to as government bonds, are issued by the U.S. federal government. These bonds have not default risk. However, these bonds decline when interest rates rise, so they are not free of all risk Corporate bonds – issued by corporate; exposed to default risk – if the issuing company gets into trouble, it may be unable to make the promised interest and principal payments. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and the terms of the specific bond. Default risk often referred to as “credit risk” and the larger the default or credit risk, the higher the interest rate the issuer must pay. Municipal bond – or “munis “ are issued by state and local governments. Like corporate bonds, munis have default risk. Munis offer one major advantage over all the other bonds is exempt from federal taxes and also from state taxes if the holder is a resident of the issuing state. Munis bonds carry interest rates that are considerably lower than those on corporate bonds with the same default risk Foreign bond – are issued by foreign governments or foreign corporations. Foreign corporate bonds are of course exposed to default risk, and so are some foreign government bonds. An additional risk exists if the bonds are denominated...

Words: 1835 - Pages: 8

Premium Essay

Free

...issuing a bond relative to stock is that the bond interest payments are tax deductible. True False 2. Issuing bonds dilutes the voting power of the common shareholders because bonds have preferential voting rights. True False 3. The major disadvantages of issuing a bond are the risk of bankruptcy and the negative impact on cash flow because debt must be repaid at a specified date in the future. True False 4. A bond's interest payments are determined by multiplying the bond's principal amount by the stated interest rate. True False 5. A convertible bond can be called for early retirement at the option of the issuing company. True False 6. The issuing company and the bond underwriter determine the selling price of a bond. True False 7. The issuance price of a bond is the present value of both the principal plus the cash interest to be received over the life of the bond discounted by the stated (coupon) rate. True False 8. When the market rate of interest is greater than the stated interest rate, the bond will sell at a discount. True False 9. A bond will sell for a premium when the market rate of interest is greater than the stated rate of interest. True False 10. The proceeds received from a bond issue will be greater than the bond maturity value when the stated interest rate exceeds the market rate of interest. True False 11. Increases in the market rate of interest subsequent to a bond issue increase the discount on the bond. True...

Words: 23435 - Pages: 94

Premium Essay

Test Bank for Fincance

...chapter 07 Interest Rates and Bond Valuation Answer Key     Multiple Choice Questions   1. Mary just purchased a bond which pays $60 a year in interest. What is this $60 called?  A. coupon B. face value C. discount D. call premium E. yield Refer to section 7.1   AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 7-1 Section: 7.1 Topic: Coupon   2. Bert owns a bond that will pay him $75 each year in interest plus a $1,000 principal payment at maturity. What is the $1,000 called?  A. coupon B. face value C. discount D. yield E. dirty price Refer to section 7.1   AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 7-1 Section: 7.1 Topic: Face value   3. A bond's coupon rate is equal to the annual interest divided by which one of the following?  A. call price B. current price C. face value D. clean price E. dirty price Refer to section 7.1   AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 7-1 Section: 7.1 Topic: Coupon rate   4. The specified date on which the principal amount of a bond is payable is referred to as which one of the following?  A. coupon date B. yield date C. maturity D. dirty date E. clean date Refer to section 7.1   AACSB: N/A Bloom's: Knowledge Difficulty: Basic Learning Objective: 7-1 Section: 7.1 Topic: Maturity   5. Currently, the bond market requires a return of 11.6 percent on the 10-year bonds issued by Winston Industries. The...

Words: 11184 - Pages: 45

Premium Essay

Bond Valuation

...Bond Valuation By Anuj Joshi Note 1 Bond Valuation Fixed income paying securities. 1. Theoretical price or value of bond depends upon. i. Coupon Payment : Fixed amount of interest to be received after prescribed frequency. ii. Maturity Value [Unless otherwise given is exam, we should take face value] iii. Discount Rate : It should always be market interest rate 2. What is market interest rate Market interest rate is derived from comparable listed bond. The comparison is based on risk and life of the bond. E.g. If we are valuing a bond which is unlisted and have 5 years of life, then we should look for a bond which is similar in risk profile (i.e. same credit rating)and having similar life. The YTM (Yield to Maturity) of listed bond is called market interest rate The YTM of a bond is nothing but IRR of the bond. 3. Value of a bond = PV of Coupon Amount + PV of Maturity Value [Remember CF and discount rate are before tax] Concept Point: i. Coupon rate is a historical rate and should never be used as a discount rate. In exam, if no other information is available, then only we should assume coupon rate of interest as market rate of interest. ii. Remember, Cost of Capital or Discount Rate is a future concept and it represents opportunity cost on the date of valuation. iii. YTM of a similar bond (i.e. current market interest rate) is the appropriate discount rate for bond valuation. How to value a bond which pays interest at a frequency lower than annually (e...

Words: 2748 - Pages: 11

Premium Essay

Chapter 6 Solutions

...Answers to Review Questions 1. The real rate of interest is the rate that creates an equilibrium between the supply of savings and demand for investment funds. The nominal rate of interest is the actual rate of interest charged by the supplier and paid by the demander. The nominal rate of interest differs from the real rate of interest due to two factors: (1) a premium due to inflationary expectations (IP) and (2) a premium due to issuer and issue characteristic risks (RP). The nominal rate of interest for a security can be defined as r1 r* IP RP. For a 3-month U.S. Treasury bill, the nominal rate of interest can be stated as r1 r* IP. The default risk premium, RP, is assumed to be zero since the security is backed by the U.S. government; this security is commonly considered the risk-free asset. 2. The term structure of interest rates is the relationship of the rate of return to the time to maturity for any class of similar-risk securities. The graphic presentation of this relationship is the yield curve. 3. For a given class of securities, the slope of the curve reflects an expectation about the movement of interest rates over time. The most commonly used class of securities is U.S. Treasury securities. a. Downward sloping: Long-term borrowing costs are lower than short-term borrowing costs. b. Upward sloping: Short-term borrowing costs are lower than long-term borrowing costs. c. Flat: Borrowing costs are relatively similar for short- and long-term loans. The upward-sloping...

Words: 5435 - Pages: 22