BMA - 12e - SM - CH - 03 - Final (AutoRecovered)

Chapter 03 - Valuing Bonds
CHAPTER 3
Valuing Bonds
The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.
Answers to Problem Sets
Prices and yields A 10-year bond is issued with a face value of $1,000, paying interest of $60 a year. If yields to maturity
increase shortly after the T-bond is issued, what happens to the bond’s
1. a. Does not change. The coupon rate is set at time of issuance.
b. Price falls. The yield to maturity and the price are inversely related.
c. Yield to maturity rises. Since the price falls, the bond’s yield to maturity will rise.
2. a. If the coupon rate is higher than the yield to maturity, then interest is more than the
Internal Rate of Return, then investors must be
expecting a decline in the capital value of the bond over its remaining life. Thus, the
bond’s price must be greater than its face value.
If a bond’s coupon rate is lower than its yield to maturity, then the bond’s price will
increase over its remaining maturity.
b. Conversely, if the yield to maturity is greater than the coupon, the price will be below
face value. The price will rise and equal face value at maturity.

Prices and yields In February 2015 Treasury 4¾s of 2041 offered a semiannually compounded
yield to maturity of 2.70%. Recognizing that coupons are paid semiannually, calculate
the bond’s price.
3. Semiannual discount rate = .027 / 2 = .0135, or 1.35%
Number of time periods = (2041 – 2015) × 2 = 52
PV(bond) = PV(annuity of coupons) + PV(principal)

Date 1 2015
Coupon rate 4.75%
Date 2 2041
YTM 2.70%
Face value 1000
PV = [(.0475 × $1,000) / 2] × ((1 / .0135) – {1 / [.0135 × (1 + .0135)52]}) + $1,000 / (1 + .0135)52
PV = $1,381.20
A 10-year German government bond (bund) has a face value of €100 and
a 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?
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4. PV(bond) = PV(annuity of coupons) + PV(principal)

PV = coupon rate * face vaue –(1/(YTM * (1+YTM)^time))+ facevalue/(1+YTM)^time
PV = (.05 × €100) × ((1 / .06) – {1 / [.06 × (1 + .06)10]}) + €100 / (1 + .06)10

PV = €92.64
If interest rates rise, do bond prices rise or fall?
5. a. Fall. Assume a one-year, 10 percent bond. If the interest rate is 10

percent, the bond is worth $110 / 1.1 = $100. If the interest rate rises to 15 percent, the
bond is worth $110 / 1.15 = $95.65.
If the bond yield to maturity is greater than the coupon, is the price of the bond greater or
less than 100?
b. Less. Using the example in part a, if the bond yield to maturity is 15 percent but the
coupon rate is lower at 10 percent, the price of the bond is less than $100.
If the price of a bond exceeds 100, is the yield to maturity greater or less than the coupon?
c. Less. If r = 5 percent, then a 1-year 10 percent bond is worth $110 / 1.05 = $104.76.
Do high-coupon bonds sell at higher or lower prices than low-coupon bonds?
d. Higher. If r = 10 percent, a 1-year 10 percent bond is worth $110 / 1.1 = $100, while a 1-
year 8 percent bond is worth $108 / 1.1 = $98.18.
If interest rates change, do the prices of high-coupon bonds change proportionately more
than that of low-coupon bonds?
e. No. Low-coupon bonds have longer durations (unless there is only one
period to maturity) and are therefore more volatile. For example. if r falls from 10 percent
to 5 percent, the value of a 2-year 10 percent annual coupon bond rises from $100 to
$109.30, which is an increase of 9.3 percent. The value of a 2-year 5 percent annual
coupon bond rises from $91.32 to $100, which is an increase of 9.5 percent.
Which comes first – spot interest rates or YTM
6. a. Spot interest rates. Yield to maturity is a complicated average of the separate spot rates
of interest.
Which comes first bond prices or YTM
b. Bond prices. The bond price is determined by the bond’s cash flows and the spot rates of
interest. Once you know the bond price and the bond’s cash flows, it is possible to
calculate the yield to maturity.
c.
What is the new yield to maturity for each bond in the table?
7. a. 4%; each bond will have the same yield to maturity.
Recalculate the price of bond A.
b. PV = $80 / (1.04) + $1,080 / (1.04) 2

PV = $1,075.44
What is the formula for the value of a two-year, 5% bond in terms of spot rates?
8. a. PV = (.05 × $1,000) / (1 + r1) + [(.05 × $1,000) + $1,000] / (1 + r2)2
. What is the formula for its value in terms of yield to maturity?
b. PV = (.05 × $1,000) / (1 + y) + [(.05 × $1,000) + $1,000] / (1 + y)2

If the two-year spot rate is higher than the one-year rate, is the yield to maturity greater or
less than the two-year spot rate?
c. Less; it is between the 1-year and the 2-year spot rates.
9. a. The 2-year spot rate is r2 = (100 / 99.523).5 – 1 = .24%.

The 3-year spot rate is r3 = (100 / 98.937)1/3 – 1 = .36%.
The 4-year spot rate is r4 = (100 / 97.904).25 – 1 = .53%.
The 5-year spot rate is r5 = (100 / 96.034).2 – 1 = .81%.
b. Upward-sloping.
c. Higher; the yield on the

bond is a complicated average of the separate spot rates.
An 8%, five-year bond yields 6%. If this yield to maturity remains unchanged, what will
be its price one year hence? Assume annual coupon payments and a face value of $100.
PV = coupon rate * face vaue –(1/(YTM * (1+YTM)^time))+ facevalue/(1+YTM)^time
10. 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
What is the total return to an investor who held the bond over this year?
Rate of return = coupon income + price change /investment

b. Return = [(.08 × $1,000) + $106.93 – 108.42] / $108.42 = .06, or 6%
c. If a bond’s yield to maturity is unchanged over the period, the annual return to the
bondholder is equal to the yield to maturity.
Longer-maturity bonds necessarily have longer durations
11. a. False. Duration depends on the coupon as well as the maturity.
b. The longer a bond’s duration, the lower its volatility.
b. False. Given the yield to maturity, volatility is proportional to duration.
Other things equal, the lower the bond coupon, the higher its volatility.
c. True. A lower coupon rate means longer duration and therefore higher volatility.
d. If interest rates rise, bond durations rise also.
d. False. A higher interest rate reduces the relative present value of distant principal
repayments.
12. Calculation of volatility and duration
Duration = proportion * time

Proportion= PV/total PV
PV= Cash flow/ (1+r)^time
Volatility = Duration/(1+yield )
Volatility
Proportion =
of Total Proportion × (Duration
Year Ct PV(C t) Value Time / (1 + r)
r = 8%
Security A 1 40 37.04 .3593 .3593

2 40 34.29 .3327 .6654
3 40 31.75 .3080 .9241
Total PV = 103.08 1.0000 Duration = 1.9487 1.80
Security B 1 20 18.52 .1414 .1414

2 20 17.15 .1310 .2619
3 120 95.26 .7276 2.1828
Security C 1 10 9.26 .0881 .0881

2 10 8.57 .0815 .1631
3 110 87.32 .8304 2.4912
13. 1-year rate in 1 year = 1.062 / 1.05 – 1

1-year rate in 1 year = .0701, or 7.01%
Est. Time: 01-05
14. a. r = 1.10 / 1 .05 – 1
r = .0476, or 4.76%
b-1. The real rate does not change.
b-2. The nominal rate increases to:
rNominal = 1.0476 × 1.07 – 1

rNominal = .1210, or 12.10%
Est. Time: 01-05
15. Using Excel:
Bond 1 YTM = 4.30%

Bond 2 YTM = 4.20%
Bond 3 YTM = 3.90%
Bond 1 Duration = 9.05

Est. Time: 01-05
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 reported yield to maturity is 5.2% (a six-month discount rate of 5.2/2 = 2.6%).
16. a. PV = (.0275 × $1,000) × ((1 / .026) – {1 / [.026(1 + .026) 10×2 ]}) + $1,000 / (1 + .026)10×2
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
Est. Time: 06-10
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 did the bondholder earn in this
case?
Po= coupon rate * face vaue –(1/(YTM * (1+YTM)^time))+ facevalue/(1+YTM)^time

Case 1 = Time is 6 years
Case 2 = time is 5 years
Rate of return = Coupon rate + price change/ investment (P0)
One-year rate of 3 percent:
P0 = (.05 × $1,000) × ((1 / .03) – {1 / [.03(1 + .03)6]}) + $1,000 / (1 + .03)6

P0 = $1,108.34
P1 = (.05 × $1,000) × ((1 / .03) – {1 / .03(1 + .03)5]}) + $1,000 / (1 + .03)5
P1 = $1,091.59
r = [(.05 × $1,000) + $1,091.59 – 1,108.34] / $1,108.34

r = .0300, or 3.00%
One year rate of 2 percent:
P0 = (.05 × $1,000) × ((1 / .03) – {1 / [.03(1 + .03)6]}) + $1,000 / (1 + .03)6

P0 = $1,108.34
P1 = (.05 × $1,000) × ((1 / .02) – {1 / [.02(1 + .02)5]}) + $1,000 / (1 + .02)5

P1 = $1,141.40
r = [(.05 × $1,000) + $1,141.40 – 1,108.34] / $1,108.34

r = .0749, or 7.49%
18. The key here is to find a combination of these two bonds (i.e., a portfolio of bonds) that has a
cash flow only at t = 6. Then, knowing the price of the portfolio and the cash flow at t = 6, we can
calculate the six-year spot rate. We begin by specifying the cash flows of each bond and using
these and their yields to calculate their current prices:
Investment Yield C1 ... C5 C6 Price

6% bond 12% 60 ... 60 1,060$753.32
10% bond 8% 100 ... 100 1,100 $1,092.46
From the cash flows in years 1 through 5, we can see that buying two 6 percent bonds produces
the same annual payments as buying 1.2 of the 10 percent bonds. To see the value of a cash
flow only in year 6, consider the portfolio of two 6 percent bonds minus 1.2 10 percent bonds.
This portfolio costs:
($753.32 × 2) – (1.2  $1,092.46) = $195.68
The cash flow for this portfolio is equal to zero for years 1 through 5 and, for year 6, is equal to:
($1,060 × 2) – (1.2  $1,100) = $800
Thus:
$195.68  (1 + r6)6 = $800
r6 = .2645, or 26.45%
Est. Time: 06-10
19. Downward sloping. This is because high-coupon bonds provide a greater proportion of their cash
flows in the early years. In essence, a high-coupon bond is a “shorter” bond than a low-coupon
bond of the same maturity.
r1 = 5.00%, r2 = 5.40%, r3 = 5.70%, r4 = 5.90%, r5 = 6.00%.
What are the discount factors for each date (that is, the present value of $1 paid in year t)?
20. a.
Year Discount factor
1 1 / 1.05 = .952
2 1 / (1.054)2 = .900
3 1/ (1.057)3 = .847
4 1 / (1.059)4 = .795
5 1 / (1.060)5 = .747
b. Face value = $1000

5 percent, two-year bond:
PV =
PV = $50 / 1.05 + $1,050 / 1.0542
PV = $992.79
ii. 5 percent, five-year bond:
PV = $50 / 1.05 + $50 / 1.0542 + $50 / 1.0573 + $50 / 1.0594 + $1,050 / 1.0605
PV = $959.34
iii. 10 percent, five-year bond:
PV = $100 / 1.05 + $100 / 1.0542 + $100 / 1.0573 + $100 / 1.0594 + $1,100 /

1.0605
PV = $1,171.43
c. First, we calculate the yield for each of the two bonds. For the 5 percent bond, this
means solving for r in the following equation:
$959.34 = $50 / (1 + r) + $50 / (1 + r)2 + $50 / (1 + r)3 + $50 / (1 + r)4 + $1,050 /

(1 + r)5
r = .05964, or 5.964%
For the 10% bond:
$1,171.43 = $100 / (1 + r) + $100 / (1 + r)2 + $100 / (1 + r)3 + $100 / (1 + r)4 +

$1,100 / (1 + r)5
r = .05937, or 5.937%
The yield depends upon both the coupon payment and the spot rate at the time of the
payment. The 10 percent bond has a slightly greater proportion of its total payments coming
earlier, when interest rates are low, than does the 5 percent bond. Thus, the yield of the 10
percent bond is slightly lower.
d. The yield to maturity on a five-year zero-coupon bond is the five-year spot rate, which is
6.0 percent.
e. First, we find the price of the five-year annuity, assuming that the annual payment is $1:
PV = $1 / 1.05 + $1/ 1.0542 + $1 / 1.0573 + $1 / 1.0594 + $1 / 1.0605

PV = $4.2417
Now we find the yield to maturity for this annuity:
$4.2417= $1 / (1 + r) + $1 / (1 + r)2 + $1 / (1 + r)3 + $1 / (1 + r)4 + $1 / (1 + r)5

r = .0575 or 5.75%
f. The yield on the five-year note lies between the yield on a five-year zero-coupon bond and
the yield on a five-year annuity because the cash flows of the Treasury bond lie between
the cash flows of these other two financial instruments during a period of rising interest
rates. That is, the annuity has fixed, equal payments; the zero-coupon bond has one
payment at the end; and the bond’s payments are a combination of these.
Est. Time: 06-10
21. To calculate the duration, consider the following table similar to Table 3.4:
Year 1 2 3 4 5 6 7 Totals
Payment ($) 30 30 30 30 30 30 1,030
24.65 782.71 939.97
PV(Ct) at 4% ($) 28.846 27.737 26.670 25.644 8 23.709 5 9
Fraction of total value
[PV(Ct)/PV] .031 .030 .028 .027 .026 .025 .833 1.000
Year × fraction of total
value .031 .059 .085 .109 .131 .151 5.829
Duration (Years) 6.395
The duration is the sum of the year × fraction of total value row, or 6.395 years.
The modified duration, or volatility, is 6.395 / (1 + .04) = 6.15.
The price of the 3 percent coupon bond at 3.5 percent, and 4.5 percent equals $969.43 and
$911.61, respectively. The price difference is $57.82, or 6.15 percent of the bond’s value at the 4
percent discount rate. The percentage difference is equal to the 1 percent change in the discount
rate × modified duration.
Est. Time: 06-10
22.
a. If the bond coupon payment changes from 9% as listed in Table 3.4 to 8%, then the
following calculation for duration can be made:
Year 1 2 3 4 5 a. 7 Totals
Payment ($) 80 80 80 80 80 80 1,080
65.75 820.71 1,240.08
PV(Ct) at 4% ($) 76.923 73.964 71.120 68.384 4 63.225 1 2
[PV(Ct)/PV] .062 .060 .057 .055 .053 .051 .662 1.000
Year × fraction of total
value .062 .119 .172 .221 .265 .306 4.633
Duration (years) 5.778
A decrease in the coupon payment will increase the duration of the bond, as the duration at an 8
percent coupon payment is 5.778 years.
The volatility for the bond in Table 3.4 with an 8 percent coupon payment is: 5.778 / 1.04 = 5.556.
The bond therefore becomes less volatile if the coupon payment decreases.
b. For a 9 percent bond whose yield increases from 4 percent to 6 percent, the duration can
be calculated as follows:
Year 1 2 3 4 5 6 7 Totals
Payment ($) 90 90 90 90 90 90 1090
67.25 1,167.47
PV(Ct) at 6% ($) 84.906 80.100 75.566 71.288 3 63.446 724.912 1
[PV(Ct)/PV] .073 .069 .065 .061 .058 .054 .621 1.000
Year × fraction of total .073 .137 .194 .244 .288 .326 4.346
value
Duration (years) 5.609
There is an inverse relationship between the yield to maturity and the duration. When the yield
goes up from 4 percent to 6 percent, the duration decreases slightly. The volatility can be
calculated as follows: 5.609 / 1.06 = 5.291. This shows that the volatility decreases as well when
the yield increases.
Est. Time: 06-10
23. The duration of a perpetual bond is: [(1 + yield) / yield].
The duration of a perpetual bond with a yield of 5% is:
D5 = 1.05 / .05 = 21 years
The duration of a perpetual bond yielding 10 percent is:
D10 = 1.10 / .10 = 11 years
Because the duration of a zero-coupon bond is equal to its maturity, the 15-year zero-coupon
bond has a duration of 15 years.
Thus, comparing the 5 percent perpetual bond and the 15-year zero-coupon bond, the 5 percent
perpetual bond has the longer duration. Comparing the 10 percent perpetual bond and the 15-
year zero, the zero has a longer duration.
Est. Time: 06-10
24. Answers will differ. Generally, we would expect yield changes to have the greatest impact on
long-maturity and low-coupon bonds.
Est. Time: 06-10
25. The new calculations are shown in the table below:
1 2 3 4 Bond Price (PV) YTM (%)
Spot rates (%) 4.60 4.40 4.20 4.00

Discount factors .9560 .9175 .8839 .8548
Bond A (8% coupon):

Payment (Ct) $80 $1,080
PV(Ct) $76.48 $990.88 $1,067.37 4.407%
Bond B (8% coupon):

Payment (Ct) $80 $80 $1,080
PV(Ct) $76.48 $73.40 $954.60 $1,104.48 4.219%
Bond C (8% coupon):

Payment (Ct) $80 $80 $80 $1,080
PV(Ct) $76.48 $73.40 $70.71 $923.19 $1,143.78 4.036%
26. We will borrow $1,000 at a five-year loan rate of 2.5% and buy a four-year strip paying 4%. We
may not know what interest rates we will earn on the last year, but we can put it under our
mattress earning 0 percent, if necessary, to pay off the loan when it comes due.
Using the information from problem 25, the cost of the strip will be $1,000 × .8548 = $854.80. The
proceeds from the 2.5 percent loan = $1,000 / (1.025) 5 = $883.85. We can pocket the difference
of $29.05, smile, and repeat.
The minimum sensible value would be to set the discount factor used in year 5 equal to that of
year 4, which would assume a 0 percent interest rate for year 5. We can solve for the interest rate
where 1 / (1 + r)5 = .8548, which is roughly 3.19%.
Est. Time: 06-10
27.
a. Based on a $100 investment:
$100 × (1 + .042)3 = $113.137

$100 × (1 + .04)4 = $116.986
1-year spot rate in three years:
($116.986 – 113.137) / $113.137 = .034, or 3.4%
b. If investing in long-term bonds carries additional risks, then the risk equivalent of a one-
year spot rate in three years would be less that the 3.4 percent, reflecting the fact that
some risk premium must be built into this 3.4 percent spot rate.
Est. Time: 06-10
28.
a. Nominal 2-year return:
1.082 – 1 = .1664, or 16.64%
Real 2-year return:
(1.08 / 1.03) × (1.08 / 1.05) – 1 = .0785, or 7.85%
b. Nominal 2-year return:
1.082 – 1 = .1664, or 16.64%
Real 2-year return:
(1.08 × 1.03) × (1.08 × 1.05) – 1 = .2615, or 26.15%
Est. Time: 01-05
29. PV = (.10 × $1,000) × ((1 / .034) – {1 / [.034(1 + .034) 5]}) + $1,000 / 1.0345
PV = $1,298.84
PV = (.10 × $1,000) × ((1 / .044) – {1 / [.044(1 + .044) 5]}) + $1,000 / 1.0445

PV = $1,246.53
30. Answers will vary by the interest rates chosen.
a. Suppose the YTM on a four-year 3 percent coupon bond is 2 percent:
PV = (.03 × $1,000) × ((1 / .02) – {1 / [.02(1 + .02)4]}) + $1,000 / (1 + .02)4

PV = $1,038.08
If the YTM stays the same, one year later the bond will sell for:
PV = (.03 × $1,000) × ((1 / .02) – {1 / [.02(1 + .02)3]}) + $1,000 / (1 + .02)3

PV = $1,028.84
r = ($30 + 1,028.84 – 1,038.08) / $1,038.08

r = .02, or 2%, which is equal to the yield to maturity
b. Suppose the YTM on a four-year 3 percent coupon bond is 4 percent:
PV = (.03 × $1,000) × ((1 / .04) – {1 / .04 × (1 + .04) 4]}) + $1,000 / (1 + .04)4

PV = $963.70
If the YTM stays the same, one year later the bond will sell for:
PV = (.03 × $1,000) × ((1 / .04) – {1 / .04 × (1 + .04) 3]}) + $1,000 / (1 + .04)3

PV = $972.25
r = ($30 + 972.25 – 963.70) / $963.70

r = .04, or 4%, which is equal to the yield to maturity
Est. Time: 06-10
31. Spreadsheet problem; answers will vary.
Est. Time: 06-10
32. Arbitrage opportunities can be identified by finding situations where the implied forward rates or
spot rates are different.
We begin with the shortest-term bond, Bond G, which has a two-year maturity. Since G is a zero-
coupon bond, we determine the two-year spot rate directly by finding the yield for Bond G. The
yield is 9.5%, so the implied two-year spot rate (r2) is 9.5 percent. Using the same approach for
Bond A, we find that the three-year spot rate (r3) is 10.0 percent.
Next we use Bonds B and D to find the four-year spot rate. The following position in these bonds
provides a cash payoff only in year four: a long position in two of Bond B and a short position in
Bond D.
Cash flows for this position are:
[(–2  $842.30) + $980.57] = –$704.03 today

[(2  $50) – $100] = $0 in years 1, 2 and 3
[(2  $1,050) – $1,100] = $1,000 in year 4
We determine the four-year spot rate from this position as follows:
$1,000
$704 . 03 =
(1 + r 4 )4
r4 = .0917 = 9.17%
Next, we use r2, r3, and r4 with one of the four-year coupon bonds to determine r1. For Bond C:
$1,065.28 = $120 / (1 + r1) + $120 / 1.0952 + $120 / 1.1003 + $1,120 / 1.09174

r1 = .3867 = 38.67%
Now, in order to determine whether arbitrage opportunities exist, we use these spot rates to value
the remaining two four-year bonds. This produces the following results: for Bond B, the present
value is $854.55, and for Bond D, the present value is $1,005.07. Since neither of these values
equals the current market price of the respective bonds, arbitrage opportunities exist. Similarly,
the spot rates derived above produce the following values for the three-year bonds: $1,074.22 for
Bond E and $912.77 for Bond F.
Est. Time: 11-15
33. We begin with the definition of duration as applied to a bond with yield r and an annual payment
of C in perpetuity:
1C 2C 3C tC
+ + +⋯+ +⋯
1 + r (1 + r)2 (1 + r )3 (1 + r)t
DUR =
C C C C
+ 2
+ 3
+ ⋯+ +⋯
1 + r (1 + r ) (1 + r ) (1 + r )t
We first simplify by dividing both the numerator and the denominator by C:
1 2 3 t
+ 2
+ 3
+⋯+ +⋯
(1 + r) (1 + r ) (1 + r) (1 + r )t
DUR =
1 1 1 1
+ + +⋯ + +⋯
1 + r (1 + r) (1 + r)
2 3
(1 + r )t
The denominator is the present value of a perpetuity of $1 per year, which is equal to (1/r). To
simplify the numerator, we first denote the numerator S and then divide S by (1 + r):
S 1 2 3 t
= + + +⋯ + +⋯
(1 + r ) (1 + r) (1 + r) (1 + r )
2 3 4
(1 + r )t + 1
Note that this new quantity [S/(1 + r)] is equal to the square of denominator in the duration
formula above, that is:
( )
2
S 1 1 1 1
= + + +⋯+ +⋯
(1 + r ) 1 + r (1 + r ) (1 + r)
2 3
(1 + r )t
Therefore:
()
2
S 1 1+ r
= ⇒ S= 2
(1 + r ) r r
Thus, for a perpetual bond paying C dollars per year:
1+ r 1 1+r
DUR = × =
r2 (1 / r) r
Est. Time: 06-10
34. One solution is:
Solve for r1:
$97.56 = $100 / (1 + r)
r1 = .025, or 2.50%
Solve for r4:
$87.48 = $100 / (1 + r)4

r4 = .034, or 3.40%
Solve for r5:
Using 1.5 times the 2 percent coupon bond and the 3 percent coupon bond, the cash flows for
years 1-4 will be eliminated so you can solve for r5:
(1.5 × $928.90) – $974.30 = [(1.5 × $1,020) – 1,030] / (1 + r5)5

r5 = .035955, or 3.5955%
Solve for r3:
Reduce the 5-year 2 percent coupon bond using r1, r4, and r5:
$928.90 = $20 / 1.025 + $20 / (1 + r2)2 + $20 / (1 + r3)3 + $20 / 1.0344 + $1,020 / 1.0359555
$37.030021 = $20 / (1 + r2)2 + $20 / (1 + r3)3
Reduce the 3-year 5 percent coupon bond using r1:
$1,054.20 = $50 / 1.025 + $50 / (1 + r2)2 + $1,050 / (1 + r3)3

$1,005.419512 = $50 / (1 + r2)2 + $1,050 / (1 + r3)3
Using the reduced 3-year bond and 2.5 times the reduced 5-year 2 percent coupon bond will
eliminate the year 2 cash flows, so you can solve for r3:
$1,005.419512 – (2.5 × $37.030021) = ($1,050 – (2.5 × $20) / (1 + r3)3

$912.844459 / $1,000 / (1 + r3)3
r3 = .030863, or 3.0863%
Solve for r2:
Using the 3-year bond and r1 and r3, solve for r2:
$1,054.20 = $50 / 1.025 + $50 / (1 + r2)2 + $1,050 / 1.0308633

$46.932036 = $50 / (1 + r2)2
r2 = .0322
Thus, the spot rates for years 1 to 5 are 2.50 percent, 3.22 percent, 3.09 percent, 3.40 percent,
and 3.60 percent, respectively.
Est. Time: 16-30
35. a. We can set up the following three equations using the prices of bonds A, B, and C:
Using bond A: $1,076.19 = $80 / (1 + r1) + $1,080 /(1 + r2)2

Using bond B: $1,084.58 = $80 / (1 + r1) + $80 / (1 + r2)2 + $1,080 / (1 + r3)3
Using bond C: $1,076.20 = $80 / (1 + r1) + $80 / (1 + r2)2 + $80/ (1 + r3)3 + $1,080 /
(1 + r4)4
We know r4 = 6 percent so we can substitute that into the last equation. Now we have
three equations and three unknowns and can solve this with variable substitution or linear
programming to get r1 = 3 percent, r2 = 4 percent; r3 = 5 percent, r4 = 6 percent.
b. We will want to invest in the underpriced C and borrow money at the current spot market
rates to construct an offsetting position. For example, we might borrow $80 at the one-
year rate of 3 percent, $80 at the two-year rate of 4 percent, $80 at the three-year rate of
5 percent, and $1,080 at the four-year rate of 6 percent. Of course the PV amount we will
receive on these loans is $1,076.20. Now we purchase the discounted bond C at $1,040
and use the proceeds of this bond to repay our loans as they come due. We can pocket
the difference of $36.20, smile, and repeat.
Est. Time: 11-15

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Chapter 03 - Valuing Bonds

Answers to Problem Sets

1. a. Does not change. The coupon rate is set at time of issuance.

3. Semiannual discount rate = .027 / 2 = .0135, or 1.35%

Number of time periods = (2041 – 2015) × 2 = 52

PV(bond) = PV(annuity of coupons) + PV(principal)

4. PV(bond) = PV(annuity of coupons) + PV(principal)

PV = (.05 × €100) × ((1 / .06) – {1 / [.06 × (1 + .06)10]}) + €100 / (1 + .06)10

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

5. a. Fall. Assume a one-year, 10 percent bond. If the interest rate is 10

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

Which comes first – spot interest rates or YTM

Which comes first bond prices or YTM

7. a. 4%; each bond will have the same yield to maturity.

Recalculate the price of bond A.

b. PV = $80 / (1.04) + $1,080 / (1.04) 2

8. a. PV = (.05 × $1,000) / (1 + r1) + [(.05 × $1,000) + $1,000] / (1 + r2)2

. What is the formula for its value in terms of yield to maturity?

b. PV = (.05 × $1,000) / (1 + y) + [(.05 × $1,000) + $1,000] / (1 + y)2

c. Less; it is between the 1-year and the 2-year spot rates.

9. a. The 2-year spot rate is r2 = (100 / 99.523).5 – 1 = .24%.

c. Higher; the yield on the

PV = coupon rate * face vaue –(1/(YTM * (1+YTM)^time))+ facevalue/(1+YTM)^time

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

Rate of return = coupon income + price change /investment

Longer-maturity bonds necessarily have longer durations

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

b. The longer a bond’s duration, the lower its volatility.

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

d. If interest rates rise, bond durations rise also.

12. Calculation of volatility and duration

Duration = proportion * time

Security A 1 40 37.04 .3593 .3593

Security B 1 20 18.52 .1414 .1414

Security C 1 10 9.26 .0881 .0881

13. 1-year rate in 1 year = 1.062 / 1.05 – 1

Est. Time: 01-05

14. a. r = 1.10 / 1 .05 – 1

b-1. The real rate does not change.

b-2. The nominal rate increases to:

rNominal = 1.0476 × 1.07 – 1

Est. Time: 01-05

15. Using Excel:

Bond 1 YTM = 4.30%

Bond 1 Duration = 9.05

Est. Time: 01-05

Est. Time: 06-10

Po= coupon rate * face vaue –(1/(YTM * (1+YTM)^time))+ facevalue/(1+YTM)^time

Rate of return = Coupon rate + price change/ investment (P0)

One-year rate of 3 percent:

P0 = (.05 × $1,000) × ((1 / .03) – {1 / [.03(1 + .03)6]}) + $1,000 / (1 + .03)6

r = [(.05 × $1,000) + $1,091.59 – 1,108.34] / $1,108.34

One year rate of 2 percent:

P0 = (.05 × $1,000) × ((1 / .03) – {1 / [.03(1 + .03)6]}) + $1,000 / (1 + .03)6

P1 = (.05 × $1,000) × ((1 / .02) – {1 / [.02(1 + .02)5]}) + $1,000 / (1 + .02)5

r = [(.05 × $1,000) + $1,141.40 – 1,108.34] / $1,108.34

Investment Yield C1 ... C5 C6 Price

($753.32 × 2) – (1.2  $1,092.46) = $195.68

($1,060 × 2) – (1.2  $1,100) = $800