Ch 04 P16 Build a Model

3/6/2003

Chapter 4. Ch 04 P16 Build a Model

Rework Problem 4-9 using a spreadsheet. After completing questions a through d, answer the new question. 4-9. A 10-year 12 percent semiannual coupon bond, with a par value of $1,000, may be called in 4 years at a call price of $1,060. The bond sells for $1,100. (Assume that the bond has just been issued.) Work parts a through d with a spreadsheet. You can also work these parts with a calculator to check your spreadsheet answers if you aren't confidient of your spreadsheet solution. You must then go on to work the remaining parts with the spreadsheet. a. What is the bond's yield to maturity? Basic Input Data: Years to maturity: Periods per year: Periods to maturity: Coupon rate: Par value: Periodic payment: Current price Call price: Years till callable: Periods till callable: YTM =

10 2 12% $1,000 $1,100 $1,060 4

This is a nominal rate, not the effective rate. Nominal rates are generally quoted. Calculate the duration using the duration function

Duration:

Use the Excel duration function to find the duration of b. What is the bond's current yield? Current yield = Ann. Coupon / / Price

c. What is the bond's capital gain or loss yield? Cap. Gain/loss yield = YTM Current yield

Note that this is an economic loss, not a loss for tax purposes. d. What is the bond's yield to call?

Here we can again use the Rate function, but with data related to the call. YTC = The YTC is much lower than the YTM because if the bond is called, the buyer will lose the difference between the call price and the current price in just 4 years, and that loss will offset much of the interest imcome. Note too that the bond is likely to be called and replaced, hence that the YTC will probably be earned. NOW ANSWER THE FOLLOWING NEW QUESTIONS: e. How would the price of the bond be affected by changing interest rates? (Hint: Conduct a sensitivity analysis of price to changes in the yield to maturity, which is also the going market interest rate for the bond. Assume that the bond will be called if and only if the going rate of interest falls below the coupon rate. That is an oversimplification, but assume it anyway for purposes of this problem.) Nominal market rate, r: Value of bond if it's not called: Value of bond if it's called: 12% The bond would not be called unless r<coupon rate = 12%.

We can use the two valuation formulas to find values under different r's, in a 2-output data table, and then use an IF statement to determine which value is appropriate: Value of Bond If: Not called Called $0.00 $0.00 Actual value, considering call likehood: Hint: Use function Wizard and pick IF function.

Rate, r 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

We can graph the above data to get another idea of the bond's price sensitivity.

If you study the graph, you will see that the "not called" situation shows the greatest price sensitivity, the "called" the least sensitivity, and the "modified" falls somewhere in between. Actually, the modified situation, which is representative of most actual bonds because most bonds are callable, shows that bondholders will not win big if rates fall because then the bond will be called, but they do lose big if rates rise because then the bonds will not be called. In terms of the graph, the sensitivity line is not steep where we want it to be steep, to the left of the 12% coupon rate, but it is steep where we do not want it to be steep, to the right of 12%. The clear conclusion is that callable bonds are riskier than non-callable bonds, and their risk is asymmetric.