FINC2011 Tutorial 4

BMA Ch.3 Problems 2, 4, 5, 10, 11, 12, 14, 15, 16, 17, 21, 28, 29

2. The following statements are true. Explain why.

a. If a bond's coupon rate is higher than its yield to maturity, then the bond will
sell for more than face value.
b. If a bond's coupon rate is lower than its yield to maturity, then the bond's
price will increase over its remaining maturity.

Answer

a. If the coupon rate is higher than the yield, then investors must be expecting a
decline in the capital value of the bond over its remaining life. Thus, the bonds price
must be greater than its face value.

b. Conversely, if the yield is greater than the coupon, the price will be below face
value and it will rise over the remaining life of the bond.

A10-year German government bond (bund) has a face value of 100 and a
4. coupon rate of 5% paid annually. Assume that the interest rate (in euros) is equal
to 6% per year. What is the bond's PV?

Answer

With annual coupon payments:

1 1 100
PV 5 10
92.64
0.06 0.06 (1.06) (1.06) 10

Construct some simple examples to illustrate your answers to the following:

5.

a. If interest rates rise, do bond prices rise or fall?

b. If the bond yield is greater than the coupon, is the price of the bond greater
or less than 100?

c. If the price of a bond exceeds 100, is the yield greater or less than the
coupon?

d. Do high-coupon bonds sell at higher or lower prices than low-coupon

bonds?

e. If interest rates change, does the price of high-coupon bonds change

proportionately more than that of low-coupon bonds?
Answer

a. Fall. Example: Assume a one-year, 10% bond. If the interest rate is 10%, the bond
is worth $110/1.1 = $100. If the interest rate rises to 15%, the bond is worth
$110/1.15 = $95.65.

b. Less (e.g., see 5aif the bond yield is 15% but the coupon rate is lower at 10%,
the price of the bond is less than $100).

c. Less (e.g., with r = 5%, one-year 10% bond is worth $110/1.05 = $104.76).

d. Higher (e.g., if r = 10%, one-year 10% bond is worth $110/1.1 = $100, while one-
year 8% bond is worth $108/1.1 = $98.18).

e.No. Low-coupon bonds have longer durations (unless there is only one period to
maturity) and are therefore more volatile (e.g., if r falls from 10% to 5%, the value
of a two-year 10% bond rises from $100 to $109.3 (a rise of 9.3%). The value of a
two-year 5% bond rises from $91.3 to $100 (a rise of 9.5%).

10. a. An 8%, five-year bond yields 6%. If the yield remains unchanged, what will
be its price one year hence? Assume annual coupon payments.

b. What is the total return to an investor who held the bond over this year?

c. What can you deduce about the relationship between the bond return over a
particular period and the yields to maturity at the start and end of that
period?

Answer

a. PV0 = (.08 $100) ((1 / .06) {1 / [.06(1 + .06)5]}) + $100 / 1.065

PV0 = $108.42

PV1 = (.08 $100) ((1 / .06) {1 / [.06(1 + .06)4]}) + $100 / 1.064

PV1 = $106.93

b. Return = (8 + 106.930)/108.425 - 1 = .06, or 6%.

c. If a bonds yield to maturity is unchanged, the return to the bondholder is equal to

the yield.

11. True or false? Explain.

a. Longer-maturity bonds necessarily have longer durations.
b. The longer a bond's duration, the lower its volatility.
c. Other things equal, the lower the bond coupon, the higher its volatility.
 d. If interest rates rise, bond durations rise also.

Answer

a. False. Duration depends on the coupon as well as the maturity.

b. False. Given the yield to maturity, volatility is proportional to duration.

c. True. A lower coupon rate means longer duration and therefore higher volatility.

d. False. A higher interest rate reduces the relative present value of (distant) principal
repayments.

12. Calculate the durations and volatilities of securities A, B, and C. Their cash
flows are shown below. The interest rate is 8%.

Answer

14. The two-year interest rate is 10% and the expected annual inflation rate is 5%.
a. What is the expected real interest rate?
b. If the expected rate of inflation suddenly rises to 7%, what does Fisher's
theory say about how the real interest rate will change? What about the
nominal rate?
Answer
 a. Real rate = 1.10/1.05 1 = .0476, or 4.76%.

b. The real rate does not change. The nominal rate increases to 1.0476
1.07 1 = .1209, or 12.09%.

Here are the prices of three bonds with 10-year maturities:

15.

If coupons are paid annually, which bond offered the highest yield to
maturity?

Which had the lowest? Which bonds had the longest and shortest durations?

Answer

Bond 1 YTM = 4.30%

Bond 2 YTM = 4.20%
Bond 3 YTM = 3.90%

Bond 1 Duration = 9.05

Bond 2 Duration = 8.42
Bond 3 Duration = 7.65

Yields to maturity are about 4.3% for the 2% coupon, 4.2% for the 4% coupon, and
3.9% for the 8% coupon. The 8% bond had the shortest duration (7.65 years), the 2%
bond the longest (9.07 years).The 4% bond had a duration of 8.42 years.

16. A 10-year U.S. Treasury bond with a face value of $1,000 pays a coupon of
5.5% (2.75% of face value every six months). The semiannually compounded
interest rate is 5.2% (a six-month discount rate of 5.2/2 = 2.6%).
a. What is the present value of the bond?
b. Generate a graph or table showing how the bond's present value changes
for semiannually compounded interest rates between 1% and 15%.

Answer

a. PV = (.0275 $1,000) ((1 / .026) {1 / [.026(1 + .026)102 ]}) + $1,000 / (1 + .

026)102
PV = $1,023.16
b.
Yield to
PV of Bond
Maturity
1% $1,427.22
2% 1,315.80
3% 1,214.60
4% 1,122.64
5% 1,038.97
6% 962.81
7% 893.41
8% 830.12
9% 772.36
10% 719.60
11% 671.36
12% 627.23
13% 586.81
14% 549.75
15% 515.76

17. A six-year government bond makes annual coupon payments of 5% and offers a
yield of 3% annually compounded. Suppose that one year later the bond still
yields 3%. What return has the bondholder earned over the 12-month period?
Now suppose that the bond yields 2% at the end of the year. What return would
the bondholder earn in this case?

Answer

Purchase price for a six-year government bond with 5% annual coupon:

1 1 1,000
PV 50 6
$1,108.34
0.03 0.03 (1.03) (1.03) 6

The price one year later is equal to the present value of the remaining five years of
the bond:
1 1 1,000
PV 50 5
$1,091.59
0.03 0.03 (1.03) (1.03)5

Rate of return = [$50 + ($1,091.59 $1,108.34)]/$1,108.34 = 3.00%

Price one year later (yield = 2%):

1 1 1,000
PV 50 5
$1,141.40
0.02 0.02 (1.02) (1.02) 5
 Rate of return = [$50 + ($1,141.40 $1,108.34)]/$1,108.34 = 7.49%.
21. Calculate durations and modified durations for the 3% bonds in Table3.2. You
can follow the procedure set out in Table3.4 for the 9% coupon bonds. Confirm
that modified duration predicts the impact of a 1% change in interest rates on
the bond prices.

Answer

To calculate the duration, consider the following table similar to Table 3.4:

Year 1 2 3 4 5 6 7 Totals
Payment ($) 30 30 30 30 30 30 1,030
PV(Ct) at 4% ($) 28.846 27.737 26.670 25.644 24.658 23.709 782.715 939.980
Fraction of total
value [PV(Ct)/PV] 0.031 0.030 0.028 0.027 0.026 0.025 0.833 1.000
Year fraction of
total value 0.031 0.059 0.085 0.109 0.131 0.151 5.829
Duration (Years) 6.395

The duration is the sum of the year fraction of total value column, or 6.395 years.

The modified duration, or volatility, is 6.395/(1 + .04) = 6.15.

The price of the 3% coupon bond at 3.5%, and 4.5% equals $969.43 and $911.61,
respectively. This price difference ($57.82) is 6.15% of the original price, which is
very close to the modified duration.

Suppose that you buy a two-year 8% bond at its face value.

28.

a. What will be your nominal return over the two years if inflation is 3% in the
first year and 5% in the second? What will be your real return?

b. Now suppose that the bond is a TIPS. What will be your real and nominal
returns?

Answer

a. Your nominal return will be 1.082 -1 = 16.64% over the two years.
Your real return is (1.08/1.03) (1.08/1.05) - 1 = 7.85%.

b. With the TIPS, the real return will remain at 8% per year, or 16.64%
over two years. The nominal return on the TIPS will equal (1.08
1.03) (1.08 1.05) 1 = 26.15%.
29. A bond's credit rating provides a guide to its price. As we write this in early
2015, Aaa bonds yield 3.4% and Baa bonds yield 4.4%. If some bad news causes
a 10% five-year bond to be unexpectedly downrated from Aaa to Baa, what
would be the effect on the bond price? (Assume annual coupons.)

Answer

The bond price at a 3.4% yield is:

1 1 1,000
PV 100 5
$1,298.84
0.034 0.034 (1.034) (1.034) 5

If the yield increase to 4.4%, the price would decrease to:

1 1 1,000
PV 100 5
$1,246.53
0.044 0.044 (1.044) (1.044) 5