TOPIC 6

INTEREST RATES AND BOND

VALUATION
Answers to Concepts Review and Critical Thinking Questions

Q6.8 Bond Ratings. Companies pay rating agencies such as Moody's and S&P to rate
their bonds, and the costs can be substantial. However, companies are not required
to have their bonds rated in the first place; doing so is strictly voluntary. Why do
you think they do it?
Companies pay to have their bonds rated simply because unrated bonds can be
difficult to sell; many large investors are prohibited from investing in unrated
issues.

Q6.15 Bond Prices versus Yields.

a. What is the relationship between the price of a bond and its YTM?
b. Explain why some bonds sell at a premium over par value while other bonds sell at
a discount. What do you know about the relationship between the coupon rate and
the YTM for premium bonds? What about for discount bonds? For bonds selling
at par value?
c. What is the relationship between the current yield and YTM for premium bonds?
For discount bonds? For bonds selling at par value?

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.

Par Bond (Coupon Rate@10%=Market Rate@10% i.e. CR=MR)

1000=FV

PV=1000 100 100 100=PMT

|_______________|___ ___________|_________---_________| I/Y=10%

0 1 2 10
ND
Calculator: 2 CLR TVM (shown only once)
1000 FV 100 PMT 10 I/Y 10 N CPT PV = 1000

Premium Bond (CR@10%>MR@9%)

1000=FV

PV=1064 100 100 100=PMT

|_______________|___ ___________|_________---_________| I/Y=9%

0 1 2 10
Calculator: 9 I/Y CPT PV = 1064

Discount Bond (CR10%<MR11%)

1000=FV

PV=941 100 100 100=PMT

|_______________|___ ___________|_________---_________| I/Y=11%

0 1 2 10
Calculator: 11 I/Y CPT PV = 941

Solutions to Questions and Problems

Q3. Bond Prices. Lycan, Inc., has 7 percent coupon bonds on the market that have 8
years left to maturity. The bonds make annual payments. If the YTM on these
bonds is 10 percent, what is the current bond price?
FV = 1000
PMT = 0.07 x 1000 = 70
N=8
I/Y = 10
1000=FV

PV= ? 70 70 70=PMT

|_______________|___ ___________|_________---_________| I/Y=10%

0 1 2 8

The price of any bond is the PV of the interest payment, plus the PV of the par
value. Notice this problem assumes an annual coupon. The price of the bond will
be:
N N
0 = -PV + PMT({1 – [1/(1 + I)] } / I) + FV[1 / (1 + I)
8 8
P = $70({1 – [1/(1 + .10)] } / .10) + $1,000[1 / (1 + .10) ]
P = $839.95

Calculator: 1000 FV 70 PMT 10 I/Y 8 N CPT PV = 839.95

We would like to introduce shorthand notation here. Rather than write (or type, as
the case may be) the entire equation for the PV of a lump sum, or the PVA
equation, it is common to abbreviate the equations as:
PVIFR,t = 1 / (1 + R)t

which stands for Present Value Interest Factor

PVIFAR,t = ({1 – [1/(1 + R)]t } / R)

which stands for Present Value Interest Factor of an Annuity

These abbreviations are shorthand notation for the equations in which the interest
rate and the number of periods are substituted into the equation and solved. We
will use this shorthand notation in the remainder of the solutions key. The bond
price equation for this problem would be:
P = $70(PVIFA10%,8) + $1,000(PVIF10%,8)
P = $839.95

Q4. Bond Yields. The Smart Choice Plc has 10 percent coupon bonds on the market
with nine years left to maturity. The bonds make annual payments. If the bond
currently sells for $1,145.70, what is its YTM?
FV = 1000
 PMT = 0.10 x 1000 = 100
N=9
PV = 1145.70
I/Y = ?

Here, we need to find the YTM of a bond. The equation for the bond price is:

P = $1,145.70 = $100(PVIFA R%,9) + $1,000(PVIF R%,9)

9 9
Or P = $1,145.70 = $100({1 – [1/(1 + R)] } / R) + $1,000[1 / (1 + R) ]

Notice the equation cannot be solved directly for R. Using a spreadsheet, a

financial calculator, or trial and error, we find:

Calculator: 1145.70 +/– PV 1000 FV 100 PMT 9 N CPT I/Y = 7.70

Therefore, R = YTM = 7.70%

Q5. Coupon Rates. Merton Enterprises has bonds on the market making annual
payments, with 16 years to maturity, and selling for $963. At this price, the bonds
yield 7.5 percent. What must the coupon rate be on Merton's bonds?

FV = 1000
PMT = ?
N = 16
PV = 963
I/Y = 7.5
Here we need to find the coupon rate of the bond. All we need to do is to set up
the bond pricing equation and solve for the coupon payment as follows:

P = $963 = C(PVIFA7.5%,16) + $1,000(PVIF7.5%,16)

16 16
Or P = $963 = C({1 – [1/(1 + 0.075)] } / 0.075) + $1,000[1 / (1 + 0.075) ]

Solving for the coupon payment, we get:

C = $70.95

Calculator: 963 +/– PV 1000 FV 7.5 I/Y 16 N CPT PMT = 70.95

Coupon payment = Coupon rate X Par value.

Therefore,
Coupon rate = $70.95 / $1,000
Coupon rate = .07095 or 7.095%
Q11. Nominal and Real Returns. An investment offers a 13 percent total return over
the coming year. Bill Bernanke thinks the total real return on this investment will
be only 6 percent. What does Bill believe the inflation rate will be over the next
year?

The Fisher equation, which shows the exact relationship between nominal interest
rates, real interest rates, and inflation, is:

(1 + R) = (1 + r)(1 + h) where R = nominal, r = real, h = inflation

h = [(1 + 0.13) / (1 + 0.06)] – 1

h = .066 or 6.60%

R≈r+h
h≈R–r
≈ 13 – 6
≈7
Q12. Nominal versus Real Returns. Say you own an asset that had a total return last
year of 17 percent. If the inflation rate last year was 2.9 percent, what was your
real return?
The Fisher equation, which shows the exact relationship between nominal interest
rates, real interest rates, and inflation, is:

(1 + R) = (1 + r)(1 + h)
r = [(1 + R) / (1 + h)] – 1
r = [(1 + 0.17) / (1.029)] – 1
r = .137 or 13.70%

R≈r+h
r≈R–h
≈ 17 – 2.9
≈ 14.1

Note: R = nominal rate = market quoted rate

 r = real rate
h = inflation rate

Q18. Bond Yields. PK Software has 7.5 percent coupon bonds on the market with 22
years to maturity. The bonds make semi-annual payments and currently sell for
106 percent of par. What is the current yield on PK's bonds? The YTM? The
effective annual yield?
The current yield is:

Current yield = Annual coupon payment / Price

Current yield = $75 / $1,060 (coupon payment = 0.075x1000
Price=1.06x1000)
Current yield = 0.0708 or 7.08%

FV = 1000
PMT = (0.075/2) x 1000 = 37.50
N = 22 x2 = 44 half-years
PV = 1.06 x 1000 = 1060
I/Y = ?

The bond price equation for this bond is:

P0 = $1,060 = $37.50(PVIFAR%,44) + $1,000(PVIFR%,44)

44 44
Or P0 = $1,060 = $37.50({1 – [1/(1 + R)] } / R) + $1,000[1 / (1 + R) ]

Using a spreadsheet, financial calculator, or trial and error we find:

Calculator: 1,060 +/– PV 1000 FV 75÷2=37.50 PMT 22x2=44 N CPT I/Y =

3.482% per half-year

R = 3.482%

This is the semiannual interest rate, so the YTM is:

YTM = 2 ´ 3.482%
YTM = 6.96%pa compounded half-yearly (APR)

The effective annual yield is the same as the EAR, so using the EAR equation
from the previous chapter:
 m
EAR = [1 + (APR / m)] – 1

²
Effective annual yield = (1 + 0.0696/2) – 1
Effective annual yield = .0708 or 7.08%

Cal: 2ndF ICONV NOM=6.96 C/Y=2 CPT EFF=7.08

Actual: 2ndF RESET ENTER
2ndF ICONV NOM=6.96 ENTER ↓↓ C/Y=2 ENTER ↑ CPT EFF=7.08pa
comp yearly
Extra Tutorial Questions – Topic 6 (Bond Valuation)

1.Suppose a bond with a 10% coupon rate and semiannual coupons, has a face value of
$1,000, 20 years to maturity and is selling for $1,197.93. Calculate the YTM.

PV=1197.93 50 50 …. 50+1000
|_______|_______|____...____| I/Y=?%
0 1 2 40

FV = 1000

PMT = 1000 x = 50
n = 20 x 2 = 40
PV = 1197.93

40 N 1,197.93 +/- PV 50 PMT 1000 FV CPT I/Y = 4% per half-year

YTM = 4% x 2 = 8%pa

2.BMW Ltd issued a set of bonds 3 years ago and has 18 months until maturity. The
bond has a face value of $1,000. The coupon on the issue is 9% pa paid in semi annual
instalments. What is the price of the bond today if the yield to maturity is 12% pa
compounded half-yearly?

PV=? 45 45 45+1000
|_______|_______|_______| I/Y=12%/2=6%
0 1 2 3

FV = 1000

PMT = 1000 x = 45

N= =3

I/Y =

2ndF Clear TVM 45 PMT 1000 FV 3 n 6 i COMP PV = 959.90