Lahore School of Economics Financial Management I Bonds and Their Valuation - 2

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Lahore School of Economics

Financial Management I
Chapter 7
Bonds and their Valuation – 2

Class Examples

Q1) Finding the nominal rate of interest, EFF = 8.16% => APR = 8%
Semiannual interest rate = 0.08/2 = 0.04 = 4%.
Solving for price:
N = 2  10 = 20, I = 4, PMT = 0.09/2  1,000 = 45, FV = 1000; PV = VB = -$1,067.95.

Q2) N = 20; PV = -1275; PMT = 120; FV = 1000; I = YTM = 8.99%.

For YTC:
N = 5; PV = -1275; PMT = 120; FV = 1120; I = YTC = 7.31%.

Since the YTC is less than the YTM, or coupon rate is higher than YTM, investors would expect the bonds to be
called and to earn the YTC.

Q3) N = 10, PV = P0 = -887, PMT = 90, FV = 1000, I = YTM = 10.91%.

Current Yield = $90/$887 = 10.14%.

Expected Capital Gains Yield = YTM – Current Yield = 10.91% – 10.14% = 0.77%.

Or, finding PV after 1 year:


N = 9; I = YTM = 10.94%; PMT = 90; FV = 1000; PV = P1 = $893.79.

Expected Capital Gains Yield = % change in Price = ( P1 - P0 ) / P0


= (893.79 – 887) / 887
= 0.77%

Q4) a. N = 18, PV = -1100, PMT = 60, FV = 1000, YTM = I/YR = 5.1355%.


The nominal YTM = 5.1355%*(2) = 10.27%.

For the YTC:


N = 8, PV = -1100, PMT = 60, FV = 1060, YTC = I/YR = 5.0748%.

The nominal YTC = 5.0748%*(2) = 10.15%.

b. The current yield = $120/$1,100 = 10.91%. The current yield will remain the same; however, if the bond is
called the YTC reflects the total return (rather than the YTM) so the capital gains yield will be different.

c. YTM (or YTC) = Current yield + Capital gains (loss) yield

As we expect YTC instead of YTM,


The expected capital loss yield = YTC – CY
= 10.15% – 10.91%
= -0.76%.

Q5) Coupon rate will be equal to the YTM at the moment.


N = 6, PV = -950, PMT = 80, FV = 1000, I = YTM = 9.12%.
Coupon rate = YTM = 9.12%.

Problems for Assignment

Q1) N = 10  2 = 20; PV = -1100; PMT = 0.08/2  1,000 = 40; FV = 1000; I = YTM = 3.31%  2 = 6.62%.

N = 5  2 = 10; PV = -1100; PMT = 0.08/2  1,000 = 40; FV = 1050; I = YTC = 3.24%  2 = 6.49%.

Q2) a. N = 28, PV = -1165.75, PMT = 95, FV = 1000, I = YTM = 8.00%.


N = 3, PV = -1165.75, PMT = 95, FV = 1090, I = YTC = 6.11%.

b. Knowledgeable investors would expect the return to be closer to 6.1% than to 8%. If interest rates remain
substantially lower than 9.5%, the company can be expected to call the issue at the call date and to refund it with an issue
having a coupon rate lower than 9.5%.

Q3) a. N = 9, PV = -901.40, PMT = 80, FV = 1000; I/YR = YTM = 9.69%.

b. Assuming that CY = $80/$901.40 = 8.875%.

CGY = YTM – CY = 9.691% – 8.875% = 0.816%.

Q4) PV = Current price.


Current yield = Annual interest/Current price
0.0821= $80/PV
PV= $80/0.0821 = $974.42.

N = 5  2 = 10, PV = -974.42, PMT = 80/2 = 40, FV = 1000, I/YR = YTM = 4.32%.


The nominal YTM = 4.32%*(2) = 8.64%.

Q5) a. As the bonds were sold at par, the YTM was equal to the coupon rate of 12%.

b. N = 25  2 = 50; I = YTM = 10/2 = 5; PMT = (0.12/2) × 1,000 = 60; FV = 1000; PV = $1,182.56

c. Current Yield = $120/$1182.56 = 10.15%.

Expected Capital Gains Yield = YTM – Current Yield = 10% – 10.15% = -0.15%.

d. N = 6.5  2 = 13; PV = P0 = -$916.42; PMT = 0.12/2  1,000 = 60; FV = 1000; I = YTM = 7%  2 =


14%.

Current Yield = $120/$916.42 = 13.09%.

Expected Capital Gains Yield = YTM – Current Yield = 14% – 13.09% = 0.91%.

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