Chapter 03 - Valuing Bonds

CHAPTER 3
Valuing Bonds

1. Bond prices and yields*. A 10-year bond is issued with a face value of $1,000, paying interest of $60
a year. If interest rates increase shortly after the bond is issued, what happens to the bond’s
a. Coupon rate?
b. Price?
c. Yield to maturity?

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.

4. Bond prices and yields*. 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?

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

PV = €92.64

5. Bond prices and yields. In November 2017, Treasury 4¾s of 2041 offered a semiannually
compounded yield to maturity of 2.6%. Recognizing that coupons are paid semiannually, calculate the
bond’s price.

5. Let’s assume that the yield is pa.  Semiannual discount rate = .026 / 2 = .0130, or 1.3%

Number of time periods = (2041 – 2017) × 2 = 48

PV = [(.0475 × $1,000) / 2] × ((1 / .013) – {1 / [.013 × (1 + .0130)48]}) + $1,000 / (1 + .013)48

PV = 1381

9. Bond returns*.
a. 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 $1,000.
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?

9. a. PV5-year = (.08 × $1,000) × ((1 / .06) – {1 /(.06 × (1 + .06)5)}) + $1,000 / (1 + .06)5

PV5-year = $1,084.25

PV4-year = (.08 × $1,000) × ((1 / .06) – {1 /(.06 × (1 + .06)4)}) + $1,000 / (1 + .06)4

PV4-year = $1,069.30

b. Rate of return = ($1,069.30 + 80.00) / $1,084.25 – 1 = 0.06 or 6%, the YTM.

c. An investor will earn the yield-to-maturity on a bond as long as the YTM is unchanged.

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Chapter 03 - Valuing Bonds

10. Bond returns. 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?

10. 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%

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

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.

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Chapter 03 - Valuing Bonds

13. Duration. Calculate the durations and volatilities (modified duration) of securities A, B, and C. Their
cash flows are shown below. The interest rate is 8%.

Period 1 Period 2 Period 3

A 40 40 40

B 20 20 120

C 10 10 110

13.

Volatility
Proportion =
of Total Proportion (Duration
Year Ct PV(Ct) 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
Total PV = 130.93 1.0000 Duration = 2.5861 2.39

Security C 1 10 9.26 .0881 .0881

2 10 8.57 .0815 .1631
3 110 87.32 .8304 2.4912
Total PV = 105.15 1.00 Duration = 2.7424 2.54

21. Spot interest rates and yields. Assume annual coupons.

a. What is the formula for the value of a two-year, 5% bond in terms of spot rates?
b. What is the formula for its value in terms of yield to maturity?
c. 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?

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

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.

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Chapter 03 - Valuing Bonds

24. Spot interest rates and yields*. You have estimated spot rates as follows:
r1 = 5.00%, r2 = 5.40%, r3 = 5.70%, r4 = 5.90%, r5 = 6.00%.
a. What are the discount factors for each date (that is, the present value of $1 paid in year t)?
b. Calculate the PV of the following bonds assuming annual coupons and face values of $1,000: (i) 5%,
two-year bond; (ii) 5%, five-year bond; and (iii) 10%, five-year bond.

24. 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. i. 5 percent, two-year bond:

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

27. Term-structure theories. The one-year spot interest rate is r1 = 5% and the two-year rate is r2 = 6%.
If the expectations theory is correct, what is the expected one-year interest rate in one year’s time?

1,06*1,06=1,05*(1+?)
27. 1-year rate in 1 year = 1.062 / 1.05 – 1
1-year rate in 1 year = .0701, or 7.01%

29. Real interest rates 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?

29. a. r(real) = 1.10 / 1 .05 – 1

r(real) = .0476, or 4.76%

b-1. The real rate does not change.

b-2. The nominal rate increases to:

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Chapter 03 - Valuing Bonds

rNominal = 1.0476 × 1.07 – 1

rNominal = .1210, or 12.10%

30. Nominal and real returns*. Suppose that you buy a two-year 8% bond at its face value.
a. What will be your total nominal return over the two years if inflation is 3% in the first year and 5% in the
second? What will be your total real return?
b. Now suppose that the bond is a TIPS. What will be your total two-year real and nominal returns?
30.
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. Real 2-year return:

1.082 – 1 = .1664, or 16.64%

Nominal 2-year return:

(1.08 × 1.03) × (1.08 × 1.05) – 1 = .2615, or 26.15%

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McGraw-Hill Education.