ANSWERS TO END OF CHAPTER QUESTIONS QUESTIONS 1. A debt obligation offers the following payments: ‘Suppose that the price of this debt obligation is $7,704, What is the yield or internal rate of return offered by this debt obligation? ‘The yield on any investment is the interest rate that will make the present value of the cash flows from the investment equal to the price (or cost) of the investment, Mathematically, the yield on any investment, y, is the interest rate that satisfies the equation: Chie 1CEe Che Cen (ty) (+yh 4yh ty where CF, = cash flow in year t, P= price of the investment, and N = number of years. The yield calculated from this relationship is also called the internal rate of return. To solve for the yield (©), we can use a trial-and-error (iterative) procedure, The objective is to find the interest rate that ‘will make the present value of the cash flows equal to the price. To compute the yield for our different interest rates must be tried until the present value of the cash flows is equal to $7,704 (the price of the financial instrument). Trying an annual interest rate of 10% gives the following present value: ‘Promised Annual Payments Present Value Years from Now (Cash Flow to Investor) of Cash Flow at 10% 1 $2,000 $1,818.18 2 $2,000 $1,652.89 3 $2,500 $1,878.29 4 $4,000 $2,732.05 Present value = $8,081.42 ‘Because the present value of $8,081.42 computed using a 10% interest rate exceeds the price of $7,704, a higher interest rate must be used, to reduce the present value. Trying an annual interest rate of 13% gives the following present value: ‘Promised Annual Payments Present Value (Cash Flow to Investor) Years from Now ch1 $2,000 $1,769.91 2 $2,000 $1,566.29 : 3 ‘$2,500 $1,732.63 4 ‘$4,000 $2,453.27 Present value = $7,522.11 Because the present value of $7,522.11 computed using a 13% interest rate is below the price of $7,704, a lower interest rate must be used, to reduce the present value. Thus, to increase the present value, a lower interest rate must be tried. Trying an annual interest rate of 12% gives the following present value: Promised Annual Payments Present Value Years from Now (Cash Flow to Investor) of Cash Flow at 12% 1 ‘$2,000 $1,785.71 2 $2,000 $1,594.39 3 $2,500 $1,779.45 4 ‘$4,000 $2,542.07 Present value = $7,701.62 Using 12%, the present value of the cash flow is $7,701.62, which is almost equal to the price of the financial instrument of $7,704. Therefore, the yield is close to 12%. The precise yield using Excel or a financial calculator is 11.987%. Although the formula for the yield is based on annual cash flows, it can be generalized to any number of periodic payments in a year. The generalized formula for determining the yield is: SCF: Pe Dee py) MMT CF cash flowin period fad n= member of periods tat (1+ y Keep in mind that the yield computed is the yield for the period. That is, if the cash flows are semiannual, the yield is a semiannual yield. if the cash flows are monthly, the yield is a monthly yield. To compute the simple annual interest rate, the yield for the period is multiplied by the ‘number of periods in the year. 2. What is the effective annual yield if the semiannual periodic interest rate is 4.3%? To obtain an effective annual yield associated with a periodic interest rate, the following formula is used: effective annual yield = (1 + periodic interest rate)" ~ 1 where m is the frequency of payments per year. In our problem, the periodic interest rate is a 35Promised Annual Payments Present Value Years from Now (Cash Flow to Investor) of Cash Flow at 11% 1 $ 100 $ 90.09 2 $ 100 $ 81.16 3 $ 100 $ 73.12 4 $1,000 $658.73 Present value = $ 903.10 Using 11%, the present value of the cash flow is equal to the price of the portfolio. Therefore, the yield is 11%. Keep in mind that the yield computed is now the yield for the period. That is, ifthe cash flows are semiannual, the yield is a semiannual yield. If the cash flows are monthly, the yield is a monthly yield. To compute the simple annual interest rate, the yield for the period is multiplied by the number of periods in the year, 10. What is the limitation of using the internal rate of return of a portfolio as a measure of the portfolio’s yield? Implicit in the internal rate of return computation is the assumption that the portfolio cash flows can be reinvested at the computed internal rate of return. Also, when we compute an internal rate of return, we annualized interest rates by multiplying by the number of periods in a year (we call the resulting value the simple annual interest rate). For example, multiplying by 2 annualizes a semiannual yield. Alternatively, an annual interest rate is converted to a semiannual interest rate by dividing by 2. This simplified procedure for computing the annual interest rate given a periodic (weekly, monthly, quarterly, semiannually, and so on) interest rate is not accurate. To obtain an effective annual yield associated with a periodic interest rate, the following formula is used: effective annual yield = (1 + periodic interest rate)" - 1 where m is the frequency of payments per year. For example, suppose that the periodic interest rate is 4% and the frequency of payments is twice per year. Then effective annual yield = (1.04)? - 1 = 1.0816 - 1 = 0.0816 or 8.16%. This is different from 8.00%, which we get by multiplying 4.00% times two. 11, Suppose that the coupon rate of a floating-rate security resets every six months at a spread of 70 basis points over the reference rate. If the bond is trading at below par value, explain whether the discount margin is greater than or less than 70 basis points. If the bond is trading below par value, then the discount margin or assumed annual spread (basis points) will be greater than 70 basis points. This is because the spread must increase to make the present value of the cash flows less than the par value. This is illustrated in Exhibit 3-1 where the bond is trading below par and the spread (basis points) had to increase in order for the present value of the cash flows to fall to a level to equal the current trading value, 4512. An investor is considering the purchase of a 20-year 7% coupon bond selling for $816 and a par value of $1,000. The yield to maturity for this bond is 9%, (a) What would be the total future dollars if this investor invested $816 for 20 years earning 9% compounded semiannually? To determine the future value of any sum of money invested today, we use the below equation: Py = Po (1 +r)" where n= number of periods, P, = future value n periods from now (in dollars), Po = original principal (in dollars), and r = interest rate per period (in decimal form). Inserting in our values, we have: P, = Po (1 +r)" = $816(1.045)* = $816(5.8163645) = $4,746.15. (b) What are the total coupon payments over the life of this bond? ‘The total dollar amount of coupon interest is found by multiplying the semiannual coupon interest by the mumber of periods: total coupon interest = nC. Thus, the total coupon payments are: nC = 40($35) = $1,400.00. (© What would be the total future dollars from the coupon payments and the repayment of principal at the end of 20 years? ‘There are several ways to approach this problem. One method is to compute the present value of the cash flows and then multiply this by the future value factor for a lump sum. Another method (which involves less work) is to compute the future value of all the cash flows. For this method, ‘we would (i) compute the future value of the annuity cash flows which isthe coupon interest plus interest on interest, and (ii) add the par value which occurs at maturity which is M = $1,000. The equation is: P, = coupon interest plus interest on interest + M=C_ where P, is the future value of all cash flows at time N, C is the amount of the semiannual coupon annuity in dollars, r = annual interest rate / number of times interest paid per year (where we ‘assume interest in reinvested at 1),n = number of times interest paid per year times the number of years, and M = par value at the end of the period. Using this formula and inserting our values, we have: “0 vase + $1,000 = $35{107.03032] + $1,000 = $3,746.06 + $1,000 = $4,746.06. (@ For the bond to produce the same total future dollars as in part (a), how much must the interest on interest be?‘We can note that the future value of the interest payment just computed in part (c) is $3,746.06 and the coupon payments over the life of the bond computed in part (b) is $1,400. The different is the interest on interest, which is $2,346.06. Another way of computing the interest on interest is to note that it is the difference between the coupon interest plus interest on interest and the total dollar coupon interest, as expressed by the formula: iors minors se[ #1) F oe . (1.045)°-1 Inserting in our values gives: $35| “> =— | ~ 40(835) = $35(107.03032] - $1.400= $3,746.06 — $1,400.00 = $2,346.06. (© Calculate the interest on interest from the bond assuming that the semiannual coupon payments can be reinvested at 4.5% every six months and demonstrate that the resulting amount is the same as in part (d). Since the computation assumes interest on interest is invested at 4.5% we have the same ‘computation given in part (d) where the yield to maturity of 4.5% was used in computation. Once again, we have: ier onnerac[ #27] nC where ris still 4.5%. Inserting in our values, we have: T 0 interest on interest = 68 ~ 40($35) = $35[107.03032] - $1,400 = $3,746.06 ~ $1,400.00 = $2,346.06 which the same amount as in part (d). 13, What is the total return for a 20-year zero-coupon bond that is offering a yield to maturity of 8% if the bond is held to maturity? For zero-coupon bonds, none of the bond’s total dollar return is dependent on the interest-on- interest component, so a 2er0-coupon bond has zero reinvestment risk if held to maturity. The yield earned on a zero-coupon bond held to maturity is equal to the promised yield to maturity. ‘This is because whenever one can reinvest the coupon payments at the yield to maturity, then the total return will be the same as the yield to maturity. Thus, the total return is 8%. 14, Explain why the total return from holding a bond to maturity will be between the yield to maturity and the reinvestment rate. ‘The yield to maturity is based upon the coupon payments and the current market value of the bond. The yield to maturity is below (above) the coupon rate if the current market value is above (below) the par value. If one could reinvest the coupon payments at the yield to maturity, then the total return would be the same as the yield to maturity. If it cannot reinvest the coupon payment at the yield to maturity then it wll be earning a rate below the yield to maturity. To illustrate assume 47the yield to maturity is 9% and you reinvest at 8%. Then your total return would have to lie between 9% and 8%. Similarly, if you are able to invest above the yield to maturity of 9%, say 10%, your total return will have to lie between 9% and 10%. In either case, it is true to say that your total return from holding a bond to maturity will be between the yield to maturity and the Teinvestment rate. 15. For a long-term high-yield coupon bond, do you think that the total retum from holding a bond to maturity will be closer to the yield to maturity or the reinvestment rate? For a longer term bond the future value of the coupon payments will be greater than the future value of the par value (which is simply the par value). For example, consider a 20-year bond paying 14% and selling at par. The future value of the $70 semiannual interest payments for 40 periods will be $13,974 and the future value of the par value is $1,000. If the reinvestment rate falls to 10%, the future value of the $70 semiannual interest payments for 40 periods will fall 39.5% to $8,456 while the future value of the par value remains unchanged at $1,000. The total return will be: [ total future dollars 0 ‘purchase price of bonds. | 1 = (9.456) - 1 = 1.0577 — 1 = 0.0578. "% a+ [288 ‘Taking this semiannual rate time two renders a total return of 11.55%. This is closer to the reinvestment rate of 10% than the yield to maturity of 14%. If the reinvestment rate increases to 18%, the future value of the interest payments will rise 108.74% to $15,196. The total return will be: total future dollars” purchase price of bonds 0.0834. Taking this semiannual rate time two renders a total return of 16.68%. This is closer to the reinvestment rate of 18% and the yield to maturity of 14%. [ $24,652 40 | —1 = [24.652] — 1 = 1.0834-1 = $1,000 We conclude that for a long-term high-yield coupon bond, that the total return from holding a ‘bond to maturity will be closer to the reinvestment rate than the yield to maturity. 16, Suppose that an investor with a five-year investment horizon is considering purchasing a seven-year 9% coupon bond selling at par. The investor expects that he can reinvest the coupon payments at an annual interest rate of 9.4% and that at the end of the investment horizon two-year bonds will be selling to offer a yield to maturity of 11.2%. What is the total return for this bond? ‘The investor has a five-year investment horizon to purchase a seven-year 9% coupon bond for $1,000. The yield to maturity for this bond is 9% since it is selling at par. The investor expects to be able to reinvest the coupon interest payments at an annual interest rate of 9.4% and that at the end of the planned investment horizon the then-two-year bond will be selling to offer a yield to ‘maturity of 11.2%. The total return for this bond is found as follows: Step 1: Compute the total coupon payments plus the interest on interest, assuming an annual reinvestment rate of 9.4%, or 4.7% every six months. The coupon payments are $45 every six 48 | |months for five years or ten periods (the planned investment horizon). Applying equation (3.7), the total coupon interest plus interest on interest is (+r > . ‘coupon interest plus interest on interest -<|: r $45[12.40162] = $558.14. Step 2: Determining the projected sale price at the end of five years, assuming that the required yield to maturity for two-year bonds is 11.2%, is accomplished by calculating the present value of Tour coupon payments of $45 plus the present value of the maturity value of $1,000, discounted at 5.6%. As seen below, the projected sale price is $961.53. projected sale price = present value of coupon payments + present value of par value = {$45[3.4970813] + $1,000{0,8041634] = $157.37 + $804.16 = $961.53. Step 3: Adding the amounts in steps 1 and 2 gives total future dollars of $558.14 + $961.53 = $1,519.67. ‘Step 4: To obtain the serniannual total return, compute the following: 1.63840)" — totalfuturedollars_]""__[ $1519.67)"" purchase price of bonds $1,000 1.042738 — 1 = 0.042738 or 4.2738%. Step 5: Double 4.2738%, for a total return of about 8.55%. 17, Two portfolio managers are discussing the investment characteristics of amortizing securities. Manager A believes that the advantage of these securities relative to nonamortizing securities is that because the periodic cash flows include principal repayments as well as coupon payments, the manager can generate greater reinvestment income. In addition, the payments are typically ‘monthly so even greater reinvestment income can be generated. Manager B believes that the need to re-invest monthly and the need to invest larger amounts than just coupon interest payments make amortizing securities less attractive. Whom do you agree with and why? For amortizing securities, reinvestment risk is even greater than for nonamortizing securities. The reason is that the investor must now reinvest the periodic principal repayments in addition to the periodic coupon interest payments. Moreover, the cash flows are monthly, not semiannually as with nonamortizing securities. Consequently, the investor must not only reinvest periodic coupon interest payments and principal, but must do it more often. This increases reinvestment risk. Thus, 49