Chapter 06 - Understanding Financial Markets and Institutions

Unit 4 answers
CHAPTER 6 – UNDERSTANDING FINANCIAL MARKETS AND INSTITUTIONS

questions

LG4 12. What are six factors that determine the nominal interest rate on a security?

Specific factors that affect nominal interest rates for any particular security include: expected
inflation, the real risk free rate, default risk, liquidity risk, special provisions regarding the use of
funds raised by a particular security issuer, and the security’s term to maturity.

CHAPTER 7 – VALUING BONDS

questions

LG3 4. Provide the definitions of a discount bond and a premium bond. Give examples.

A discount bond is simply a bond that is selling below its par value. It would be quoted at a price
that is less than 100 percent of par, like 99.05. A premium bond is a bond selling above its par
value. Its price will be quoted as over 100 percent of par value, like 101.15. A bond becomes a
discount bond when market interest rates rise above the bond’s coupon rate. A bond becomes a
premium bond when market interest rates fall below the bond’s coupon rate.

LG5 6. All else equal, which bond’s price is more affected by a change in interest rates, a short-term
bond or a longer-term bond? Why?

All else equal, a long-term bond experiences larger price changes when interest rates change than
a short-term bond. A bond’s price is the present value of all its cash flows. Changes in the
discount rate (the interest rate) impact present values more for cash flows that are further out in
time.

LG5 7. All else equal, which bond’s price is more affected by a change in interest rates, a bond with a
large coupon or a small coupon? Why?

The price of the bond with the small coupon will be impacted more by a change in interest rates
than the price of the large coupon bond. For a small coupon bond, the cash flows are weighted
much more toward the maturity date because of the small interest payments. The large coupon
bond has high interest payments, many of which occur soon. These higher cash flows made

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 Chapter 06 - Understanding Financial Markets and Institutions

earlier dampen the impact of interest rate changes because those changes in the discount rate
impact the earlier cash flows to a lesser degree than the later cash flows.

LG6 9. Compare and contrast the advantages and disadvantages of the current yield computation
versus yield to maturity calculations.

The current yield computation is useful because it is a very simple one. It provides a quick and
easy assessment of what the bond offers the investor in return. But it measures only the return
from the interest payments. The full return to an investor also includes the capital gain or loss the
bond will experience if it is selling as a discount or premium bond. The yield to maturity
computation is more difficult, but it incorporates the full return the bond offers to investors.

problems

LG1 7-1 Interest Payments Determine the interest payment for the following three bonds: 3.5
percent coupon corporate bond (paid semiannually), 4.25 percent coupon Treasury note,
and a corporate zero coupon bond maturing in 10 years. (Assume a $1,000 par value.)

3.5 percent coupon corporate bond (paid semiannually): 0.5 × 0.035 × $1,000 = $17.50
4.25 percent coupon Treasury note: 0.5 × 0.0425 × $1,000 = $21.25
Corporate zero coupon bond maturing in 10 years: 0.00 × $1,000 = $0

LG6 7-13 Current Yield What is the current yield of a 3.8 percent coupon corporate bond quoted at
a price of 102.08?

3.8% / 102.08% = 0.0372 = 3.72%

LG5 7-26 Bond Prices and Interest Rate Changes A 6.5 percent coupon bond with 14 years left to
maturity is priced to offer a 7.2 percent yield to maturity. You believe that in one year, the yield
to maturity will be 6.8 percent. What is the change in price the bond will experience in dollars?

Compute the current bond price:

Bond Price = $32.50× [ 1−

0.036 ]
(1+0.036 )28 $ 1,000
+
( 1+0.036 )28
=$567.42+$371.47=$ 938.89

or TVM calculator: N = 28, I = 3.6, PMT = 32.50, FV = 1000; CPT PV = -938.89

Now compute the price in one year: PMT =

Coupon bond

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 Chapter 06 - Understanding Financial Markets and Institutions

Bond Price = $32.50× [ 1−

0.034 ]
(1+0.034 )26
+
$1,000
( 1+0.034 )26
=$555.14+$419.24=$ 974.38

or TVM calculator: N = 26, I = 3.4, PMT = 32.50, FV = 1000; CPT PV = -974.38

So, the dollar change in price is:

$974.38 − $938.89 = $35.49

LG6 7-28 Yield to Maturity A 4.30 percent coupon bond with 14 years left to maturity is offered for
sale at $943.22. What yield to maturity is the bond offering? (Assume interest payments are
semiannual.)

TVM calculator: N = 28, PV = -943.22, PMT = 21.5, FV = 1,000; CPT I = 2.432% YTM =
2.432% × 2 = 4.86%

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