FBIM602 BOND VALUATION TUT0RIAL SOLUTIONS(2017)

QUESTION ONE

Answer:
1. Par or face value - We generally assume a $1,000 par value, but par can be anything, and
often $5,000 or more is used. With registered bonds, which is what are issued today, if you
bought $50,000 worth, that amount would appear on the certificate.
2. Coupon rate- The dollar coupon is the "rent" on the money borrowed, which is generally
the par value of the bond. The coupon rate is the annual interest payment divided by the par
value, and it is generally set at the value of r on the day the bond is issued.
3. Maturity This is the number of years until the bond matures and the issuer must repay the
loan (return the par value).
4. Issue date - his is the date the bonds were issued.
5. Default risk- is inherent in all bonds except treasury bonds--will the issuer have the cash to
make the promised payments? Bonds are rated from AAA to D, and the lower the rating the
riskier the bond, the higher its default risk premium, and, consequently, the higher its
required rate of return, r

QUESTION 2

B because it has a lower coupon rate

QUESTION 3
PV= PRESENT VALUE OF COUPONS + PRESENT VALUE OF MATURITY VALUE
USING A FINANCIAL CALCULATOR
PV OF COUPONS, C=70 N=5 I/Y=8 PV = 279.4897
PV OF FV (1000) = 680.583197
PV OF BOND = 279.4897 + 680.583197
= 960.0728

QUESTION 4
PV= PRESENT VALUE OF COUPONS + PRESENT VALUE OF MATURITY VALUE
USING A FINANCIAL CALCULATOR
C= 0.1 * 1000=100 N=5 I/Y=8 FV = 1000
Bo= 1079.85
QUESTION 5
Value of bonds Pb = 50 x6.7327(PVIFannuity) + 10000x 0.7307
= 1067.34
Total debt = 1067.34 x 100 000
=106.734m

Question6

Formula: then solve for “r”.

Calculator entries to find the YTM are N = 10, PV = -750, PMT = 80 (8 x 10 years), FV =
1,000, CPT = I/Y???? YTM = 12.52.
The current yield = Coupon PMT/PV = 80/750 = 10.67%.
Then we use the relationship YTM = Current yield + Capital gain yield.
12.52% = 10.67% + Capital gain yield

Alternatively:

PV = FV/(1+ r)n + [Coupon x (1 - 1/(1 + r)n/r)]

PV = R1000/(1 + 0.12520)10 + [80 x (1 – 1/(1 + 0.1252)10/0.1252] = R763.85.
so Capital gain yield = (763.85 – 750)/750 x 100 = 1.85%

This year's price is R1,000 since the YTM equals the coupon rate.
Calculator entries for next year's price are N = 7, I/Y = 7, PMT = 60, FV = 1,000, CPT PV- ?
PV= -R946.11
 At the end of 1 year you'll have R946.11 + R60 = R1,006.11

 HPR = [E(D1) + (E(P1) – Po)]/Po = 1,006.11/1,000 - 1 = 0.6107%

 HPR = 0.61%

Question 7
7.1. Calculate the current yield [5 Marks]
Current yield = Coupon/Price = R70/R960 = 0.0729 = 7.29%

7.2. Calculate the yield to maturity [5 Marks]

Using a financial calculator [N = 10; PV = –960; FV = 1000; PMT = 35] YTM = ???
Then compute the interest rate.
YTM = 3.993% semiannually or 7.986% annual bond equivalent yield.

Question 8
(a) The coupon bonds have a 9% coupon which matches the 9% requiredreturn, so they will
sell at par; the number of bonds to be issued is$10M/$1,000 = 10,000.
(b) For the zero coupon bonds, the price is given by P0= $1,000/1.0930=$75.37; and so
$10M/$75.37 = 132,679 zero coupon bonds will be issued.
(c) For coupon bonds, the last repayment is 10,000 x $1,045 = $10.45M
d) For zeroes, the (only) repayment is 132,679 x $1,000 = $132,679,00

Question 9
a) The bond price is the present value when discounting the future cash flows from a bond;
YTM is the interest rate used in discounting the future cash flows (coupon payments and
principal) back to their present values.
b) If the coupon rate is higher than the required return on a bond, the bond will sell at a
premium, since it provides periodic income in the form of coupon payments in excess of that
required by investors on other similar bonds. If the coupon rate is lower than the required
return on a bond, the bond will sell at a discount, since it provides insufficient coupon
payments compared to that required by investors on other similar bonds. For premium bonds,
the coupon rate exceeds the YTM; for discount bonds, the YTM exceeds the coupon rate, and
for bonds selling at par, the YTM is equal to the coupon rate.
c) Current yield is defined as the annual coupon payment divided by the current bond price.
For premium bonds, the current yield is less than the YTM, for discount bonds the current
yield exceeds the YTM, and for bonds selling at par value, the current yield is equal to the
YTM. In all cases, the current yield plus the expected one-period capital gains yield of the
bond must be equal to the required return.

Question 10
Duration- setting the duration of the portfolio equal to the investor’s time horizon and making
sure the initial present value of the bond equals the present value of the liability in question.
Convexity
Question 11
VB= $100(PVIFA10%,10) + $1,000(PVIF10%,10)
= $100 ((1-1/(1+.1)^10)/0.10)+ $1,000 (1/(1+0.10)^10).
Value Of Bond = $1,000.00

Using the formulas, we would have, at r = 13 percent,

VB(10-YR) =$100(PVIFA13%,10)+$1,000(PVIF13%,10)
= $100 ((1- 1/(1+0.13)^10)/0.13) + $1,000 (1/(1+0.13)^10)
=$542.62+$294.59
=$837.21.
In a situation like this, where the required rate of return, r, rises above the coupon rate, the
bonds' values fall below par , so they sell at a discount

VB(10-YR) =$100(PVIFA7%,10)+$1,000(PVIF7%,10)
= $100 ((1- 1/(1+0.07)^10)/0.07) + $1,000 (1/(1+0.07)^10)
=$702.36+$508.35
=$1,210.71.

Thus, when the required rate of return falls below the coupon rate, the bonds' value rises
above par, or to a premium . Further, the longer the maturity, the greater the price effect of
any given interest rate change.

At maturity, the value of any bond must equal its par value (plus accrued interest). Therefore,
if interest rates, hence the required rate of return, remain constant over time, then a bond's
value must move toward its par value as
the maturity date approaches, so the value of a premium bond decreases to $1,000, and the
value of a discount bond increases to $1,000 (barring default).

Question 12
Answer:
Interest rate risk , which is often just called price risk , is the risk that a bond will lose value
as the result of an increase in interest rates. Earlier, we developed the following values for a
10 percent, annual coupon bond:

r 1-year Maturity Change 10 year Change

5% $1040 1386 38.8%
10 1000 4.8% 1000 25.1%
15 956 4.4% 749

A 5-percentage point increase in r causes the value of the 1-year bond to decline by only 4.8
percent, but the 10-year bond declines in value by more than 38 percent. Thus, the 10-year
bond has more interest rate price risk
The longer the maturity, the greater the change in value for a given change in interest rates, rd

Question 13

Answer:
Investment rate risk is defined as the risk that cash flows (interest plus principal repayments)
will have to be reinvested in the future at rates lower than today's rate. To illustrate, suppose
you just won the lottery and now have $500,000. You plan to invest the money and then live
on the income from your investments. Suppose you buy a 1-year bond with a YTM of 10
percent.
Your income will be $50,000 during the first year. Then, after 1 year, you will receive your
$500,000 when the bond matures, and you will then have to reinvest this amount. If rates
have fallen to 3 percent, then your income will fall from $50,000 to $15,000. On the other
hand, had you bought 30-year bonds that yielded 10% , your income would have remained
constant at $50,000 per year. Clearly, buying bonds that have short maturities carries
reinvestment rate risk. Note that long maturity bonds also have reinvestment rate risk, but the
risk applies only to the coupon payments, and not to the principal amount. Since the coupon
payments are significantly less than the principal amount, the reinvestment rate risk on a
long-term bond is significantly less than on a short-term bond.