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Besley: Chapter 7

Homework #4
Pg. 324 7-1
Pg. 325 7-7
Pg. 328 7-14
Pg. 324 7-1
Suppose Ford Motor Company sold an issue of
bonds with a ten-year maturity, a $1,000 par
value, a ten percent coupon rate, and semiannual
interest payments.
Two years after the bonds were issued, the going
rate of interest on bonds such as these fell to 6%. At
what price would the bonds sell.
Bond Value = INT(PVIFA
3%
,
16
) + M(PVIF
3%
,
16
)
= 50(12.5611) + 1,000(0.6232)
= $1,251.26

Pg. 324 7-1
Suppose that, two years after the initial
offering, the going interest rates had risen to
12%. At what price would the bond sell?

Input:
Output:
N I/Y PV
PMT
FV
16 6
898.94
50
1,000
Pg. 324 7-1
Suppose that the conditions in part (a) existed
that is, interest rates fell to six percent two
years after the issue date. Suppose further
that the interest rate remained at six percent
for the next eight years. Describe what would
happen to the price of the of the Ford Motor
Company bonds over time.
The price of the bond will decline toward $1,000.
Page 325 7-7
In January of 1994, the yield on AAA rated
corporate bonds averaged about 5%; by the end of
the year the yield on these same bonds was about
8% because the Federal Reserve increased interest
rates six times during the year. Assume IBM
issued a 10-year, 5% coupon bond on January 1,
1994. On the same date, General Motors issued a
20-year, 5% coupon bond. Both bonds pay
interest annually. Also assume that the market
rate on similar risk bonds was 5% at the time the
bonds were issued.
Page 325 7-7
Compute the market value of each bond at the time of
issue.
Both bonds would have sold at par since the coupon
rate was equal to the original YTM.
N=10; I=5%; PMT=50; FV=1,000
Compare the market value of each bond one year
after issue if the market yield for similar risk bonds
was 8% in 1/1/95.
V
IBM
=50(6.2469)+1,000(0.5002) = $812.55

V
GM
=50(9.6036)+1,000(0.2317) = $711.88
Page 325 7-7
Compute the 1994 capital gains yield for each bond.
Capital Gains
IBM
=(812.55-1,000)/1,000=-18.75%
Capital Gains
GM
=(711.88-1,000)/1,000=-28.81%
Compute the current yield for each bond in 1994.
The current yield for both bonds was $50/1,000 = 5%
Compute the total return each bond would have
generated for investors in 1994.
Total Return
IBM
=5%+(-18.75%) = -13.75%
Total Return
GM
=5%+(-28.81%) = -23.81%
Page 325 7-7
If you invested in bonds at the beginning of 1994, would you have
been better off to have held long-term or short-term bonds? Explain
why.
The IBM bond, which has the shorter ter to maturity, lost less than the GM
bond. The price of the shorter-term bond changes less with each change in
interest rates.
Assume interest rates stabilize at the January 1995 rate of 8.5%, and
they stay at this level indefinitely. What would be the price of each
bond on January 1, 2000 after six years from the date of issue have
passed? Described what should happen to the prices of these bonds
as they approach their maturities.
V
IBM
= $885.35; V
GM
= 719.65
At maturity, the values of both bonds will be equal to $1,000. The closer
the maturity value, the quicker the market value will approach its face
value.
Page 328 7-14
The Severn Companys bonds have four years remaining to
maturity. Interest is paid annually, the bonds have a $1,000 par
value, and the coupon interest rate is 9%.
Compute the approximate yield to maturity for the bonds if the current
market price is either (1) $829 or (2) $1,104.
Approx. YTM = INT+[(M-V
d
)/N]/[2V
d
+M]/3

V
d
=$829 Approx YTM=132.75/886 = 14.98
V
d
=$829 Approx YTM=64/1,069.33 = 5.99%
Would you pay $829 for one of these bonds if you thought that the
appropriate rate of interest was 12%-that is, if k
d
=12%. Explain.
V
d
=$90(PVIFA
12%,4
)+$1,000(PVIF
12%,4
)
=$90(3,0373+1,000(0.6355) = 908.86
If the bond was selling at $829, it would be a bargt.