196Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter11
BondValuation
.1

Outline

Learning Goals
I.

TheBehaviorofMarketInterestRates
A) KeepingTabsonMarketInterestRates
B) WhatCausesInterestRatestoMove?
C) TheTermStructureofInterestRatesandYieldCurves
1. TypesofYieldCurves
2. PlottingYourOwnCurves
3. ExplanationsoftheTermStructureofInterestRates
a. ExpectationsHypothesis
b. LiquidityPreferenceTheory
c. MarketSegmentationTheory
d. Whichtheoryisright?
4. UsingtheYieldCurveinInvestmentDecisions
ConceptsinReview

II.

ThePricingofBonds
A) AnnualCompounding
B) SemiannualCompounding
ConceptsinReview

III. MeasuresofYieldandReturn
A) CurrentYield
B) YieldtoMaturity

197Gitman/JoehnkFundamentalsofInvesting,NinthEdition

1. UsingSemiAnnualCompounding
2. YieldProperties
3. FindingtheYieldonaZero
C) YieldtoCall
D) ExpectedReturn
E) ValuingaBond
ConceptsinReview

Chapter11BondValuation198

IV. DurationandImmunization
A) TheConceptofDuration
B) MeasuringDuration
1. DurationforaSingleBond
2. DurationforaPortfolioofBonds
C) BondDurationandPriceVolatility
D) UsesofBondDurationMeasures
1. BondImmunization
ConceptsinReview
V.

BondInvestmentStrategies
A) PassiveStrategies
B) TradingonForecastedInterestRateBehavior
C) BondSwaps
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
11.1. TheBondInvestmentDecisionsofKelleyandErinCoates
11.2. GraceDecidestoImmunizeHerPortfolio
ExcelwithSpreadsheets

.2

Key Concepts

1.

Theimportantrolethatinterestratesplayinthebondinvestmentprocessandthebasicdeterminants
ofmarketrates.

2.

Thetermstructureofinterestratesandyieldcurves.

3.

Fundamentalsofbondvaluation,includingbasicmeasuresofyieldandreturn.

4.

Theconceptofdurationanditsmeasurement;howdurationisappliedinimmunizingbondportfolios.

5.

Varioustypesofbondinvestmentprogramsandthewaysdebtsecuritiescanbeusedbyinvestors.
Employmentofbondladdersisapassivestrategy,whereasbuyinghighdurationbondspriorto
interestratedropswouldbeamoreactiveandriskystrategy.

199Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.3

Overview

Chapter11BondValuation200

1.

Interestratesareanintegralcomponentofthebondvaluationprocess.Someclasstimeshouldbe
spentdiscussingtheeconomicsofinterestrates.Thevariousforcesthatdriveinterestratesshouldbe
coverednext.Inthiscontext,theinstructorcanintroducethetermstructureofinterestrates.

2.

Thetextthenpresentsthreedifferentexplanationsofthetermstructureofinterestrates:the
ExpectationsHypothesis,theLiquidityPreferenceTheory,andtheMarketSegmentationTheory.The
discussionofthisimportanttopicshouldincludeyieldcurves,howtheyareplotted,andtheirusein
makinginvestmentdecisions.

3.

Thenextsectiondiscussesthebondvaluationprocess.Itshowshow,giventhemarketrateofinterest
andotherdetailsregardingthebond(suchasthematurity,coupon,andfacevalue),itispossibleto
computethecorrectpriceofthebond.Anexampleshowingthiscomputationshouldbeworkedout
inclass,includinghowfluctuationsinthemarketinterestratesinducechangesinthepriceofthe
bond.Themagnitudeofpricechangesdependsontheamountofchangeinthemarketinterestrate,as
wellasonthematurityandcouponofthebond.

4.

Theconceptsofbondyieldsandreturns,alongwiththecomputationanduseofcurrentyield,
promisedyield,yieldtocall,andexpectedyield,arediscussednext.Theinstructormaywishto
demonstratethetrialanderrorprocedure,tocalculatetheyieldtomaturityusingtables.Itisalso
importanttoemphasizethatwhatmatterstoinvestorsisthereturnfromthebond,notitsyield.

5.

Bonddurationisoneofthemostimportantconceptsinbondvaluationandinvesting.After
demonstratingtheshortcomingsofyieldtomaturity,theconceptandmeasurementofdurationcan
beillustrated.Inthisregard,theinstructorcanworkoutanexampletoillustratehowdurationand
modifieddurationaidinvestorsingaugingabondspricevolatility.

6.

Bondimmunizationispresentednext.Thistechniquepreservesthevalueofabondportfolio.Bond
immunizationinvolvesconstructingabondportfoliowithaweightedaveragedurationthatmatches
theinvestorsinvestmenthorizon.

7.

Bondinvestmentstrategiescanbeeitheractiveorpassive.Passiveinvestmentstrategiesincludebuy
andholdandbondladders.Tradingoninterestrateswingsandbondswapsareconsideredactive
strategies.Theinstructormightpointouttheadvantagesanddisadvantages(risks)ofeachtechnique.

8.

Oneinterestingteachingstrategyistostartoutwithabondpricedatparandshowthedecine/rise
fromaninterestratedecrease/increaseofthesamemagnitude.Duetoconvexity,bondpriceswillrise
fasterthantheydecline!

.4
1.

Answers to Concepts in Review

Thereisnosinglemarketrateofinterestapplicabletoallsegmentsofthebondmarket.Instead,a
seriesofmarketyieldsexistsforavarietyofmarketinstruments.Ingeneral,theinterestrateona
particularbondissuewilldependonavarietyofissuecharacteristics,includingthetypeofissuer,the
amountoftaxexposure,itscallfeature,coupon,andtimetomaturity.Theinvestmentimplicationsof
suchamarketaresimple:Investorscanpickthesegmentswhichhavethereturn,risk,andother
characteristicsthatbestmeettheirinvestmentneeds.Forexample,theycanmovefromagencybonds
withafairlylowreturn(andrisk)tocorporatebondsandreceiveahigherreturn.Inshort,itopensup
theinvestmentalternativesandinvestmentopportunitiesforinvestors.

201Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2.

Thebehaviorofinterestratesisperhapsthesinglemostimportantelementindeterminingthelevelof
returnfromabondinvestmentprogram.Interestratesaffectthelevelofcurrentincomeearnedby
conservativeinvestors,aswellastheamountofcapitalgainsgeneratedbyaggressivebondtraders.
Whereasconservativeinvestorsareprimarilyconcernedwiththelevelofinterestrates,aggressive
investorsareinterestedchieflyinmovementsininterestrates(theamountofinterestratevolatility).
Someofthemajordeterminantsofinterestratesinclude:inflation,themoneysupply,thedemandfor
loanablefunds,theamountofdeficitspendingbytheFederalGovernment,andactionsoftheFederal
Reserve(likechangesinthediscountrate).Individualinvestorscanmonitorinterestratesand
formulateinterestrateexpectationsonaninformalbasisthroughtheuseofreportsobtainedfrom
theirbrokers,frominvestorservices(e.g.,S&PsCreditweek),and/orbyfollowingcolumns/articles
insuchbusinessandfinancialpublicationsasTheWallStreetJournalorBusinessWeek.

3.

Thetermstructureofinterestratesistherelationshipbetweentheinterestrateoryieldandthetimeto
maturityforanyclassofsimilarrisksecurities.Theyieldcurveisjustagraphicrepresentationofthe
termstructureofinterestratesatagivenpointintime.Toplotayieldcurve,youneedtoknowtheyield
tomaturityfordifferentmaturitiesofsimilarriskbonds.Asmarketconditionschange,theyieldcurves
shapeandlocationalsochange.
Theupwardslopingyieldcurveindicatesthatyieldstendtoincreasewithlongermaturities.The
longerabondhastogotomaturity,thegreaterthepotentialforpricevolatilityandtheriskofloss.
Thus,investorsrequirehigheryieldsonlongermaturitybonds.Flatyieldcurvesindicatethatyields
willbethesameacrossmaturities.Giventhatlongertermbondshavemoredefaultandmaturityrate
risk,aflatyieldcurveimpliesthatinflationratesareexpectedtodecline.

4.

Analyzingthechangesinyieldcurvesovertimeprovidesinvestorswithinformationaboutfuture
interestratemovementsandhowtheycanaffectpricebehaviorandcomparativereturns.For
example,ifoveraspecifictimeperiod,theyieldcurvebeginstorisesharply,itusuallymeansthat
inflationisincreasing.Investorscanexpectthatinterestrates,too,willrise.Undertheseconditions,
mostseasonedbondinvestorswouldturntoshortorintermediate(threetofiveyearmaturities).A
downwardslopingyieldcurvewouldsignalthatrateshavepeakedandareabouttofall.
Differencesinyieldsondifferentmaturitiesataparticularpointintime,orthesteepnessofthe
curve,isanindicationthatlongtermratesarelikelytofallsomewhattonarrowthespread,providing
anincentivetoinvestinlongertermsecurities.Steepyieldcurvesaregenerallyviewedasasignsthat
longtermratesareneartheirpeak.
Evenamonglongertermmaturities,thespreadbetweendifferentlongertermmaturitiesshouldbe
consideredbeforemakingadecisiontoinvest.Forexample,ifthespreadbetween10and30year
maturitiesisnotlargeenough(say,lessthan20basispoints),thentheinvestorshouldfavorthe
10yearbond,becausehewouldnotgainenoughtocompensateforinvestinginthemuchriskier
30yearmaturity.Inanycase,theinvestorwouldhavetoconsiderhisorherownrisktoleranceto
determinewhethertheriskpremiumwassufficientfortheadditionalriskofbuyinglongerterm
securities.
Bondpricesaredrivenbymarketyields.Inthemarketplace,theappropriateyieldatwhichthebond
shouldsellisdeterminedfirst,andthenthatyieldisusedtofindthepriceofthebond.Theyieldisa
functionofcertainmarketandeconomicforces,suchastheriskfreerateandinflation,aswellaskey
issueandissuercharacteristics,suchasthematurityoftheissueandagencyratingassignedtothe
bond.
Youcannotvalueabondwithoutknowingitsmarketyield,whichfunctionsasthediscountrateinthe
bondvaluationprocess.

5.

Chapter11BondValuation202

6.

Bondsareusuallypricedusingsemiannualcompoundingbecauseinpractice,mostbondspayinterest
everysixmonths.Semiannualcompoundingmakesdiscountingofsemiannualcouponpayments
moreprecise,resultinginmoreaccuratevaluation.However,usingannualcompoundingsimplifies
thevaluationprocessabitanddoesnotmakeverymuchdifferenceinvalue.Withhighercoupons
andlongermaturities,thedifferenceincreasesmore.Bondsofferingsemiannualpaymentswillbe
pricedhigher.

7.

Currentyieldisameasureofabondscurrentincome.Itistheamountofcurrentincomeabond
providesrelativetoitsprevailingmarketprice.Yieldtomaturityisamorecompletemeasureand
evaluatesbothinterestincomeandpriceappreciation.Yieldtomaturityindicatesthefully
compoundedrateofreturnearnedbyaninvestor,giventhatthebondisheldtomaturityandall
principalandinterestpaymentsaremadeinapromptandtimelyfashion.
Promisedyieldisthesameasyieldtomaturity.Promisedyieldiscomputedassumingthebondis
heldtomaturityandthecouponcashflowsarereinvestedatthebondscomputedpromisedyield.
Realizedyieldistherateofreturnaninvestorcanexpecttoearnbyholdingabondoveraperiodof
timethatislessthanthelifeoftheissue.Realizedyieldisusedbybondtraderswhotradeinandout
ofbondsovershortholdingperiods.

8.

Whenwearedealingwithsemiannualcashflows,tobetechnicallycorrect,weshouldfindthe
bondseffectiveannualyield.Butthemarketconventionforfindingtheannualyieldistodouble
thesemiannualyield.Thispracticeproduceswhatthemarketreferstoasthebondequivalentyield.
Thus,givenasemiannualyieldof4%,accordingtothebondequivalentyieldconvention,theannual
rateofreturnofthisbondifheldtomaturityis8%.Thisisalsothesameasthebondspromised
yieldoryieldtomaturity.

9.

Thereinvestmentofinterestincomeisanimportantconsideration,becauseitisthisratethatan
investormustearnoneachoftheinterimcashthrowoffsinordertorealizeareturnequaltoor
greaterthanthepromisedyieldonabond.Ascashisreceivedfrominterestincome,theequationfor
promisedyieldimplicitlyassumesthiscashpaymentwillbereinvestedatarateofreturnequaltothe
issuespromisedyield;failuretodosomeanstheinvestorwillgeneratearealizedyieldthatisless
thanpromised.

10. Durationisameasureofbondpricevolatility.Itcapturesbothpriceandreinvestmentrisksina
singlemeasureandindicateshowabondspricewillreacttodifferentinterestrateenvironments.Itis
theeffectivematurityofafixedincomesecurity.Ontheotherhand,thebondsactualmaturitydoes
notconsiderallofthebondscashflowsnordoesitconsiderthetimevalueofmoney.Durationisa
farsuperiormeasureoftheeffectivetimingofabondscashflows,becauseitexplicitlyconsiders
boththetimevalueofmoneyandthebondscouponandprincipalpayments.
Whenthemarketundergoesabigchangeinyield,durationwillunderstatepriceappreciationwhen
ratesfallandoverstatethepricedeclinewhenratesincrease.Modifieddurationisusedtoovercome
thisproblembylinkinginterestratechangestochangesinbondprice.First,youcancomputethe
modifieddurationusingthebondscomputeddurationandthecomputedyieldtomaturity.Then,the
changeinbondpricebaseduponachangeininterestratescanbecomputedasfollows:
Percentchangeinbondprice1ModifieddurationChangeininterestrates

203Gitman/JoehnkFundamentalsofInvesting,NinthEdition

11. Marketinterestratechangeshavetwoeffects:thepriceeffectandthereinvestmenteffect,which
occurinoppositedirections.Whenabondportfolioisimmunized,thesetwoeffectsexactlyoffset
eachotherandleavethevalueoftheportfoliounchanged.Thishappenswhentheweightedaverage
durationofthebondportfolioisexactlyequaltothedesiredinvestmenthorizon.Ifaportfoliois
constructedandcontinuouslyrebalancedsuchthattheweightedaveragedurationisequaltothe
desiredinvestmenthorizonatanyparticularpointintime,thentheportfolioissaidtobeimmunized
fromtheeffectsofinterestratechanges.
Bondimmunizationallowsaninvestortoderiveaspecifiedrateofreturnfrombondinvestments
regardlessofwhathappenstomarketinterestratesoverthecourseoftheholdingperiod.Thatis,the
investorsbondportfolioisimmunizedfromtheeffectsofchangesinmarketinterestratesovera
giveninvestmenthorizon.
Portfolioimmunizationisnotapassiveinvestmentstrategy;itrequirescontinualportfolio
rebalancingonthepartoftheinvestorinordertomaintainafullyimmunizedportfolio.The
compositionoftheportfolioshouldchangeeverytimeinterestrateschange,andalsowiththepassage
oftime.
12. Bondladdersareapassiveinvestmentstrategywherebyanequalamountofmoneyisinvestedina
seriesofbondswithstaggeredmaturities.Supposeaninvestorwantstoconfineherinvestingtofixed
incomesecuritieswithmaturitiesof10yearsorless.Shecouldsetuptheladderbyinvestingin
roughlyequalamountsof3,5,7,and10yearissues.Whenthe3yearissuematures,theproceeds
wouldbereinvestedinanew10yearnote.Similarrolloverswouldoccurwheneverabondmatures.
Eventually,theinvestorwouldholdafullladderofstaggered10yearnotes.Rollingintonew10year
issueseverytwoorthreeyearsallowstheinvestortodoakindofdollarcostaveragingandthereby
lessentheimpactofswingsinmarketrates.
Taxswapsinvolvereplacementofabondwithacapitallosswithasimilarsecurity.Bysellingthe
bondwiththecapitalloss,aninvestorcanoffsetacapitalgaingeneratedinanotherpartofthe
portfolioandtherebyreducetheoveralltaxliability.Identicalissuescannotbeusedforthiskindof
swap;theIRSwillrulesuchswapsaswashsalesandthereforedisallowthecapitalloss.
13. Anaggressivebondinvestorwouldemploythehighlyriskyforecastedinterestratebehaviorstrategy.
Theintentofthisstrategyistotakeadvantageofinterestrateswingsbytimingthemarket.Usually
theseswingsareshortlived,soaggressivebondtraderswilltrytomagnifytheirreturnsbytradingon
margin.Theseinvestorstrytogeneratecapitalgainswheninterestratesareexpectedtodeclineandto
preservecapitalwhenanincreaseininterestratesisexpected.
14. Theinterestsensitivityofabonddetermineshowmuchthebondspricewillfluctuateforagiven
changeininterestrates.Obviously,whenratesdrop,bondtraderswanttocapitalizeonthisandas
such,requireissuesthatwillrespondtotheseinterestratechanges.Bondswithlongermaturities
and/orlowercouponsrespondmorevigorouslytochangesinmarketrates;therefore,theyundergo
greaterpriceswings.Highgradeissuesarewidelyusedbyactivebondtraderssincetheseissuesare
generallymoreinterestsensitivethanlowerratedbondsforexample,marketbehaviorissuchthata
tripleAcorporatewillgenerallybefarmoreresponsivetointerestratesthanatripleBissue.A
deterioratingeconomywillresultinadeclineinthedemandformoneyandhenceinterestrates,butit
mightcausemoredefaultrisktotheholderofthetripleBbondissue.

Chapter11BondValuation204

.5

Suggested Answers to Investing in Action Questions

Theres More to Bond Returns than Yield Alone (p. 472)

Whatisthedifferencebetweenbondyieldanditsreturn?
Answer:
Thetotalreturnonabondconsistsoftheinitialyield,interestonreinvestedinterest,andbondprice
changes.Onlyinthecaseofshortterminvestmentsisyieldagoodmeasureofreturn.Forlongerterm
bonds,themostimportantfactoristheinterestearnedononesinvestment.Overasingleyear,akeyto
returnisthechangeinpriceofonesbond.Bondpricechangescanswampcouponratesandbondyields.
Bondswithhighcouponpaymentsarenormallypricedatapremium,whichreducestheyieldonthese
investments.Furthermore,onehastobecognizantofchangesinbondpricearisingfromshiftininterest
rates,firmquality,andotherfactors.

Getting Started in Bond Investment (p. 486)

(a) Whataretheadvantagesanddisadvantagesofbuyingbondsdirectly?
(b) Whataretheadvantagesanddisadvantagesofbuyingbondmutualfunds?
Answers:
(a) Individualbondinvestmentadvantagesincludeknowledgeoftheinterestrateandparvaluepayments
andtiming.(Zerocouponbondsdatescanbepurchasedatadiscountandcanbechosensothattheir
maturitymatchesyourinvestmenthorizon.)However,itisdifficulttofindinformationonindividual
bonds.Anindividualbondmightbecalled,whilebondmutualfundssimplyreinvesttheproceedsin
otherbondswithouttheneedforinvestoractivity.Researchhasshownthatittakes$50,000invested
inbondstobewelldiversified.
(b) Purchaseofabondmutualfundresultsininvestmentinadiversifiedsetofbondmeetingan
investmentobjective.Bankruptcyonthepartofsomeissuersisunlikelytowipeoutaninvestors
position.Bondfundmanagersalsohavemoreinformationresourcesattheirfingertipsinorderto
assesstheissuerabilitytomeetpaymentobligations.However,thereareloadfees,managementfees,
andtransactionfees.Inadditiononeisunabletobenefitfrompositiveresultsofasingleissuer(e.g.,
improvedqualityresultinginalowerrequiredrateofreturnandhenceahigherbondprice).Since
mutualfundsarecontinuallybuyingnewbonds,youcannotpredictaspecificcashflowonafuture
date.Aswithindividualbonds,thosefundswithhigherdurationswillbemoresensitivetointerestrate
changes.Whilethedurationofanindividualbonddeclineswithtimeasabondapproachesmaturity,
thedurationofabondfundismoreconstant.

.6
1.

Suggested Answers to Discussion Questions

Expectationshypothesis:Theyieldcurvereflectsinvestorexpectationsaboveallelse.Future
behaviorofinterestrateswithrespecttothepresentisaffectedmostbyexpectationsregarding
inflation.Higherexpectedinflationrequireshigherinterestratestoday.Theresultisanupward
slopingyieldcurve.Toproduceadownwardslopingyieldcurveunderthishypothesis,theexpected
futureinflationwouldbelower,butthecurrentrateswouldremainhigher.

205Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Liquiditypreferencetheory:Longtermbondratesshouldbehigherthanshortertermduetothe
conditiontherearemoreliquidmarketratesintheshortterm.Uncertaintyincreasesovertime
causingthedemandforahigherriskpremium(bondinterestrate).Thistheoryexpectsupward
slopingyieldcurves.Downwardslopingcurveswouldnotoccurinthistheorysinceitwould
contradictthebasicnotionthatuncertaintyincreaseswithtimeandtheriskpremiumadjusts
accordingly.
MarketSegmentationtheory:Thedebtmarketissegmentedaccordingtolengthofmaturityand
preferences.Anequilibriumexistsintheshorttermbetweensuppliersanddemandersoffunds.There
aredifferentinhabitantsineachsegmentwithdifferentmotivations.Intheshortterm,banks
predominate,butinthelongterm,lifeinsuranceandrealestatefirmsdeterminetheequilibriums.In
thistheoryyieldcurvesmaybeeitherupwardordownwardsloping,asdeterminedbythegeneral
relationshipbetweenratesineachmarketsegment.
2.

Answerswillvarywitheachstudentandtheconditionsprevailinginthemarketsatthetimethe
assignmentismade.

3.

(a)
(b)
(c)
(d)

4.

(a) Anaggressiveinvestorwouldbemoreconcernedwithcapitalgains,thatis,priceappreciation.
Inthisprocess,wewouldadvisehertoinvestinnewcompaniesthatmaybefoundontheOTC
markets.Thesecompanieshavehigherriskbuthigherreturns.Wemightalsosuggestamore
speculativestrategysuchasmarginbuyingorshortsellingdependentonthecurrentconditionsin
themarkets.
(b) Averyconservativeinvestormightincludeonlyinvestmentgradecorporate,government,and
municipalbondsinherportfolio.Thiswouldproduceaminimumofmarketlossesandrisk.
(c) (1) aninsurancecompanythatmustrelyonpredictableincomestreams
(2) aninvestorwhowantstomaximizeyield
(3) anindividualorinstitutionthatisnotasconservative
(4) aninvestorwhohasabuyandholdinvestmentstrategyandaspecificdateatwhichthe
fundswillbeneeded

5.

Answerswillvarywitheachstudent.

.7
1.

Higheryieldsleadtoshorterdurations,loweryieldsleadtolongerdurations.
Longermaturitiesmeanlongerdurations,shortermaturitiesmeanshorterdurations.
Highercouponsresultinshorterdurations,lowercouponsresultinlongerdurations.
Yieldtomaturityhasincreased.

Solutions to Problems
BondA:$1,000parvalue,5%coupon,15yearlife,pricedtoyield8%
BondB:$1,000parvalue,7.5%coupon,20yearlife,pricedtoyield6%
BondA,witha5%couponandan8%yield,mustsellatadiscount;itwillbepricedbelow$1,000.
BondB,ontheotherhand,isapremiumbond(itscouponisgreaterthanitsyield)anditwillsellata
muchhigherpricethanBondA:
PriceofBondA $50PVIFA8%,15yrs.$1,000PVIF8%,15yrs.
$508.560$1,0000.315
$428315$743
PriceofBondB $75PVIFA6%,20yrs.$1,000PVIF6%,20yrs.

Chapter11BondValuation206

$7511.470$1,0000.312
$860.25312$1,172.25

207Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2.

Bondpricesusingsemiannualcompounding:
(a) 10%,15years,YTMof8%
Price $52.50PVIFA4%,30yrs.$1,000PVIF4%,30yrs.
$52.5017.292$1,000(0.308)
$907.83$308$1,215.83
(b) 7%,10years,YTMof8%:
Price $35PVIFA4%,20yrs.$1,000PVIF4%,20yrs.
$3513.590$1,000(0.456)
$475.65$456$931.65
(c) 12%,20years,YTMof10%:
Price $60PVIFA5%,40yrs.$1,000PVIF5%,40yrs.
$6017.159$1,000(0.142)
$1,029.54$142$1,171.54
Bondpricesusingannualcompounding:
(a) 10%,15years,YTMof8%:
Price $105PVIFA8%,15yrs.$1,000PVIF8%,15yrs.
$1058.559$1,000(0.315)
$898.70$315$1,213.70
(b) 7%,10years,YTMof8%:
Price $70PVIFA8%,10yrs.$1,000PVIF8%,10yrs.
$706.710$1,000(0.463)
$469.70$463$932.70
(c) 12%,20years,YTMof10%:
Price $120PVIFA10%,20yrs.$1,000PVIF10%,20yrs.
$1208.514$1,000(0.149)
$1,021.68$149$1,170.68
Thepricedifferenceusingthetwocompoundingmethodsare:

Semiannual
Annual
Difference

(a)
Premium
$1,215.83
1,213.70
$2.13

(b)
Discount
$931.65
932
.70
$1.05

(c)
Premium
$1,171.54
1,170

.68
$0.86

Overall,thedifferencebetweenbondpricescomputedusingeithermethodareverysmall,rangingin
absolutevaluefrom$0.86to$2.13.Astheabovecomparisondemonstrates,ifabondsellsata
premiumitsvalueishigherwithsemiannualcompounding.Whenitsellsatadiscount,itsvalueis
greaterwithannualcompounding.
3.

PVIFA9%,15periods8.061
PVIF9%,15periods0.275
Bondprice($758.061)($1,0000.275)$604.58$275$879.57

Chapter11BondValuation208

4.

PVIFA4%,40periods19.793
PVIF4%,40periods0.208
Bondprice($5019.793)($1,0000.208)$989.65$208$1,197.65

5.

Returninterestincomepluspriceappreciation
Return$100$50$150
Holdingperiodreturn$150/$9000.1667or16.67%.

6.

Currentyieldisequaltoannualincomedividedbycurrentprice
$80/$1,1500.0696or6.9%.

7.

Priceofbondtoday(8%,18years,10%yield):
Price $80PVIFA10%,18yrs.$1,000PVIF10%,18yrs.
$808.201$1,000(0.180)
$656.08$180$836.08
Priceofbondinoneyear(8%,17years,9%yield):
Price $80PVIFA9%,17yrs.$1,000PVIF9%,17yrs.
$808.544$1,000(0.231)
$683.52$231$914.52
Iftheinvestorsexpectationsareaccurate,thepriceofthebondshouldgoupby$78.44($914.52)
$836.08)overthenextyear.Theholdingperiodreturnwillbe:
HPR Annualinterestincome

Capitalgains
Purchaseprice
$80 $78.44
18.95%

$836.08

8.

$1,170.68(1,000PVIFx%,20periods)($120PVIFAx%,20periods)
Using20yearsand10%
($1,0000.149)($1208.514)$149$1,021.68$1,170.68
Calculatorsolution:

20N,1170.58PV,120PMT,1000FV
CPTI/Y10.0%

9.

$1,098.62(1,000PVIFx%,20periods)($90PVIFAx%,20periods)
Using20yearsand8%
($1,0000.215)($1209.818)$215$883.62$1,098.62
Calculatorsolution:

20N,1098.62PV,90PMT,1000FV
CPTI/Y8.0%

209Gitman/JoehnkFundamentalsofInvesting,NinthEdition

10. Currentyield

Annualinterestincome
Currentmarketpriceofbond
$100 *
8.33%
$1, 200

*Annualinterestincome0.10$1,000(assumedfacevalue).
Usingannualcompounding,thepromisedyield(YTM)onthebondcanbecalculatedasfollows:
Currentprice:$1,200
CouponPayment:$100
Holdingperiod25years
FuturePrice$1,000
Letr%bethepromisedyield.Wehavethefollowing:
1,200100PVIFAr%,25period$1,000PVIFr%,25period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,thepromised
yieldis:8.1%
UsingSemiAnnualCompounding,thepromisedyield(YTM)onthebondcanbecalculatedas
follows:
Currentprice:$1,200
CouponPayment:$100250
Holdingperiod25years250periods
FuturePrice$1,000
Letr%bethepromisedYield.Wehavethefollowing:
1,20050PVIFAr%,50period$1,000PVIFr%,50period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,thepromised
semiannualyieldis:4.06%
Hencetheannualpromisedyield4.06%28.12%
11. (a) Currentyield Annualinterestincome/Currentmarketpriceofthebond
$100
$1200
8.33%

YieldtoMaturity(usinginterpolation)foramarketpriceof$1200
PV@4%($50PVIFA4%,50periods)($1000PVIF4%,50periods)
$1215($5021.482)($100021.482)
PV@5%($50PVIFA5%,50periods)($1000PVIF5%,50periods)
$999($5018.256)($10000.087)
InterestRate
4%
I
5%

BondPrice
$1215
1200
$999

$15difference

$216difference

Chapter11BondValuation210

YTM4%(15/216)(1%)4%0.07%4.07%28.14%
YieldtoCall
PV@3%
$1226.30
PV@4%
$1132.25

($50PVIFA3%,10periods)($1075PVIF3%,10periods)
($508.530)(10750.744)426.50799.80
($50PVIFA4%,10periods)($1075PVIF4%,10periods)
($508.111)($10750.676)405.55726.70

InterestRate
3%
I
4%

BondPrice
$1226
1200
$1132

$26difference

$94difference

YTC3%(26/94)(1%)4%0.277%3.287%26.56%
Thus,theYTConthisbondis6.56%whiletheYTMis8.14%.Bondtraderswouldcompare
bothrates.Sincetheconventionistousethelowermoreconservativemeasureofyieldasthe
appropriateindicatorofvalue,wewouldusetheYTCof6.56%.CalculatorSolution:
CalculatorSolution:
YTM:50N,1200PV,50PMT,1000FV;CPTI/Y4.0628.12%
YTM:10N,1200PV,50PMT,1075FV;CPTI/Y3.2726.54%
$100
$850
11.8%

(b) CurrentYield

YieldtoMaturity(usinginterpolation)foramarketpriceof$850
PV@5%
$999.80
PV@6%
$842.10

($50PVIFA5%,50periods)($1000PVIF5%,50periods)
($5018.256)($10000.087)
($50PVIFA6%,50periods)($1000XPVIF6%,50periods)
($5015.762)($10000.054)

InterestRate
5%
I
6%

BondPrice
$999
$149difference
850
$842

$157difference

YTM5%(149/157)(1%)5%0.95%5.95%211.9%

211Gitman/JoehnkFundamentalsofInvesting,NinthEdition

YieldtoCall(usinginterpolation)foramarketpriceof$850
PV@7%
$897.30
PV@8%
$833.23

($50PVIFA7%,10periods)($1075PVIF7%,10periods)
($507.024)($10750.508)
($50PVIFA8%,10periods)($1000PVIF8%,10periods)
($506.710)($10750.463)

InterestRate
7%
I
8%

BondPrice
$897
$47difference
850
$833

$64difference

YTC7%(47/64)(1%)7%0.734%7.73%215.46%
CalculatorSolution:
YTM:50N,850PV,50PMT,1000FV;CPTI/Y5.94211.9%
YTM:10N,850PV,50PMT,1075FV;CPTI/Y7.73215.47%
12. BondA:
Since10.5%isaninterestratethatdoesnotappearinthetables,itisnecessarytouseacalculatorto
pricethebond.
N20240semiannualperiods
I/Y10.5/25.25percentpersemiannualperiod
PMT0.09($1,000)/2$45persemiannualperiod
FV$1000
ComputePV$875.59
Currentyield
90
10.3%
$876
YieldtoMaturity
PV@5%
914
PV@6%
774

$45PVIFA5%,40period$1000PVIF5%,40period
(4517.159)(10000.142)
$45PVIFA6%,40period$1000PVIF6%,40period
(4515.046)(10000.097)

InterestRate
5%
I
6%

BondPrice
$914
$38difference
876
$774

$140difference

YTM5%(38/140)(1%)5%0.27%5.27%210.54%

Chapter11BondValuation212

YieldtoCall(usinginterpolation)foramarketpriceof$876
PV@6%
$917
PV@7%
$849

($45PVIFA6%,40periods)($1000PVIF6%,40periods)
($457.360)($10500.558)331.20585.90
($45PVIFA7%,10periods)($1050PVIF7%,10periods)
($457.024)($10500.508)316.08533.40

InterestRate
6%
I
7%

BondPrice
$917
876
$849

$41difference

$68difference

YTC6%(41/68)(1%)6%0.60%6.60%213.2%
BondB:
Since7.5%isaninterestratethatdoesnotappearinthetables,itisnecessarytouseacalculatorto
pricethebond.
N20annualperiods
I/Y7.5percentperyear
PMT$80peryear
FV$1000
ComputePV$1,050.97
Currentyield
7.6%

$80
$1,051

YieldtoMaturity(usinginterpolation)foramarketpriceof$1051
PV@7%
1105.52
PV@8%
1000.44
YTM

$80PVIFA7%,20period$1000xPVIF7%,20period
(8010.594)(10000.258)
$80PVIFA8%,20period$1000PVIF8%,20period
(809.818)(10000.215)
7%(54.52/105.08)1%7%052%7.52%

YieldtoCall(usinginterpolation)foramarketpriceof$1051
PV@7%
$1076.65
PV@8%
$1034.49

($80PVIFA7%,5periods)($1050PVIF7%,5periods)
($804.100)($10500.713)328748.65
($80PVIFA8%,5periods)($1050PVIF8%,5periods)
($803.993)($10500.681)319.44715.05

YTC

7%(25.65/42.16)(1%)7%0.61%7.61%

13. PVIFPrice/Par0.209.PVIFof0.209for15years11%.
CalculatorSolution:
15N,209PV,1000FV;CPTI/Y11.0%

213Gitman/JoehnkFundamentalsofInvesting,NinthEdition

14. PriceParPVIF$1,0000.422$422.00.
CalculatorSolution
10N,9I/Y,1000FV;CPTPV$422.41
15. Bondterms:25years,zerocoupon,pricedat11.625(priceof$116.25).
Currentyield

Annualinterestincome
Currentmarketpriceofbond
$0
$116.25

Theeasiest(andmostaccurate)waytofindthepromisedyieldofazerocouponissuewithouta
calculatorthathasthetimevalueofmoneyfunctionistousethetableofpresentvalueinterestfactors
(TableB.3intheappendix).FirstsolveforthePVIFinthebasicpresentvalueequation:
$116.25 $1,000PVIF
PVIF

$116.25
0.116
$1,000

The25yearfactorinTableB.3thatsequal(orclose)to0.116is9%,whichliesattheintersectionof
25yearsand9%.(Note:Usingtheapproximateyieldequationresultsinapromisedyieldofonly
6.33%,afigurethatisntevenclosetotherealpromisedyieldwhichillustrateswhyapproximate
yieldisnotaveryaccuratemeasureofreturnforzerocouponbonds.)
CalculatorSolution
25N,116.25PV,1000FV;CPTI/Y8.99%
Tofindthepriceofthiszerocouponbond,findthepresentvalueat12%of$1,000(parvalue)in25
years:
Bondprice $1,000PVIF12%,25yrs.
$1,0000.059$59
CalculatorSolution:
25N,12I/Y,1000FV;CPTPV$58.82
16. Usingannualcompounding,therealizedyieldonthebondcanbecalculatedasfollows:
Currentprice:$800
CouponPayment:$80
Holdingperiod3years
FuturePrice$950
Letr%bethepromisedyield.Wehavethefollowing:
95080PVIFAr%,3period$950PVIFr%,3period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,therealized
yieldis:15.38%
Ifthisisaninemonthholdingperiod,theholdperiodreturnis:
HPR

$950 $800 $60

26.25%
$800

Chapter11BondValuation214

The15.38%islowerthanthe26.25%holdingperiodreturn.Thelatterisforninemonths,whilethe
formerisanannualyield.Dividingtheninemonthholdingperiodby0.75putsbothratesonan
annualbasis;thatis,26.25/0.7535%annualrateofreturn.

215Gitman/JoehnkFundamentalsofInvesting,NinthEdition

17. (a) Bondterms:9%,20years,pricedat$957.43

Currentprice:$957.43
CouponPayment:$95
Holdingperiod20years
FuturePrice$1,000
Letr%betheYieldToMaturity.Wehavethefollowing:
957.4395PVIFAr%,20period$PVIFr%,20period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theYTM
is:10%
(b) Bondterms:16%,15years,pricedat$1,684.76
Currentprice:$1,684.76
CouponPayment:$160
Holdingperiod15years
FuturePrice$1,000
Letr%betheYieldToMaturity.Wehavethefollowing:
1,684.76160PVIFAr%,15period$1,000PVIFr%,15period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theYTM
is:8%
(c) Bondterms:5%,18years,pricedat$510.65
Currentprice:$510.65
CouponPayment:$55
Holdingperiod18years
FuturePrice$1,000
Letr%betheYieldToMaturity.Wehavethefollowing:
510.6555PVIFAr%,18period$1,000PVIFr%,18period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theYTM
is:12.42%
18. ModifieddurationMacaulayDuration/(1Yield)9.5/1.0758.84.
19. Percentchangeinbondprice1modifieddurationchangeininterestrates
ModifieddurationMacaulayDuration/(1Yield)8.62/1.087.98.
Percentchangeinbondprices17.980.0050.0399or3.99%
20. Percentchangeinbondprice1modifieddurationchangeininterestrates
ModifieddurationMacaulayDuration/(1Yield)8.62/1.087.98.
Percentchangeinbondprices17.980.0050.0399or3.99%
21. Tocalculatethedurationofthebond,firstcalculatethebondscurrentmarketprice:
Bondterms:10%coupon,20years,8%YTM
Price $100PVIFA8%,20yrs.$1,000PVIF8%,20yrs.
$1009.818$1,0000.215
$981.80$215$1,196.80

Chapter11BondValuation216

Durationanalysis:10%coupon,20years,8%YTM
(1)

Year
(t)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

(2)
Weighted
Annual
CashFlow
(C)
$100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
100
1,100

(3)
PVIF
(8%)
0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.292
0.270
0.250
0.232
0.215

(4)
PresentValue
ofCashFlows
(2)(3)
$92.60
85.70
79.40
73.50
68.10
63.00
58.30
54.00
50.00
46.30
42.90
39.70
36.80
34.00
31.50
29.20
27.00
25.00
23.20
236.50

(5)
PC(Ct)
Dividedby
CurrentPrice
oftheBond
4/$1,196.80
0.07737
0.07161
0.06634
0.06141
0.05690
0.05264
0.04871
0.04512
0.04178
0.03869
0.03585
0.03317
0.03075
0.02841
0.02632
0.02440
0.02256
0.02089
0.01939
0.19761
Duration

(6)
Time
Relative
CashFlow
(1)(5)
0.07737
0.14322
0.19902
0.02564
0.28450
0.31584
0.34097
0.36096
0.37602
0.38960
0.39435
0.39804
0.39975
0.39774
0.39480
0.39040
0.38352
0.37602
0.36841
3.95220
10.19years

217Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Modifiedduration

Durationinyears
1 Yieldtomaturity
10.19
9.44
1 0.08

%changeinbondprice 1Modifieddurationchangeininterestrates
19.441%9.44%
Ifmarketyieldsrise1%,thepriceofthebondwillfallby9.44%:
Priceinoneyear $100PVIFA9%,19yrs.$1,000PVIF9%,19yrs.
$1008,950$1,0000.194
$895$194$1,089
Thechangeinbondpriceis$107.80,or9%ofthepurchaseprice.Thechangeinpriceusingthe
modifieddurationmethodis9.44%,overstatingtheactualpricechangeby0.44%.Durationis
thereforenotagoodpredictorofpricevolatilityifinterestratesundergoabigswing.Sincetheprice
yieldrelationshipofabondisconvexinformbutdurationisnotthedurationmeasurewill
overstatethepricedeclineasthemarketexperiencesabigincreaseinrates.Here,althoughbetter,the
modifieddurationoverstatedthedeclinebyalmost0.5%.
22. Thisquestionisaboutbondpricevolatility.Weneedtomeasuretheresponsivenessofabondsprice
toagivenchangeinmarketinterestrates.Tomaximizecapitalgains,weneedtoselectthebondthat
hasthemaximumpricevolatility.Todothis,firstcalculatethemodifieddurationofeachbondusing
thefollowingformula:
Modifiedduration

Durationinyears
1 Yieldtomaturity

Thencalculatethepricechangewiththefollowingformula:
%changeinbondprice1Modifieddurationchangeininterestrates
(a) Bondwithdurationof8.46yearswithYTMof7.5%:
Modifiedduration

8.46
7.87%
1 0.075

%changeinbondprice 17.870.5%3.94%
(b) Bondwithdurationof9.30yearswithYTMof10%:
9.30
8.45%
1 0.10
%changeinprice 18.450.5%4.23%
Modifiedduration

(c) Bondwithdurationof8.75yearswithYTMof5.75%:
8.75
8.27%
1 0.0575
%changeinprice 18.270.5%4.135%
Modifiedduration

Bond(b)offersthepotentialformaximumcapitalappreciation.Tomaximizegains,thisbondshould
beselectedovertheothers.

Chapter11BondValuation218

(Note:Thisquestioncanbeanswereddirectlybylookingatthemodifiedduration.Foragiven
changeininterestrates,thebondwiththehighestmodifieddurationwilloffermaximumprice
appreciationpotential.Bond(b),withthehighestmodifiedduration,isthechoicefortheinvestor
whowishestomaximizecapitalgains.
23. Currentpriceofthebondsat9%marketinterest:
Zerocouponbond:
Price$1,000PVIFA9%,25yrs.$1,0000.116$116
7%,20yearbond(assumeannualpayments):
Price $75PVIFA9%,20yrs.$1,000PVIFA9%,20yrs.
$759.129$1,0000.178$862.68
Pricesbasedon7%ratein1year:
Zerocouponbond:
Price$1,000PVIFA7%,24yrs.$1,000.197$197
7%,19yearbond(assumeannualpayments):
Price $75PVIFA7%,19yrs.$1,000PVIFA7%,19yrs.
$7510.336$1,000.277$1,052.20
Capitalgains:
Zerocouponbond:Gain$197$116$81
7%bond:
Gain$1,052.20862.68$189.52
Tomaximizecapitalgainsperbond,buythe7%,20yearbond;butthisdoesnttakeintoaccount
thebigdifferenceintheamount(cost)invested.Todothat,weshouldcompareholdingperiod
returns:
HPR
Zerocouponbond:
7%bond:

Interest Capitalgains
Purchaseprice

$81
69.8%
$116
$75 $189.52
30.7%
HPR
$862.68
HPR

Theconclusionremainsunchanged.Maryshouldpurchasethezerocouponbond.
WeknowfromChapter9thatpricesofbondswithlowercouponsand/orlongermaturitieswill
respondmorevigorouslytochangesinmarketrates.Thisisexactlywhythezerocouponbond
providedbettercapitalgainsthanthe7%bondasmarketrateswentdown;thezerocouponbond
paysnointerestand,inthiscase,hadalongermaturitythantheotherbond.
Thedurationofazerocouponbondisequaltoitsactualmaturity,whilethedurationofacoupon
bearingbondisalwayslessthanitsactualmaturity.Inthiscase,thezerocouponbondsdurationis
longer(25years)thanthatofthe7%couponbond.Thezerocouponbond,withitslongerduration,
shouldbemorepricevolatilethantheotherbondunderconsideration.

219Gitman/JoehnkFundamentalsofInvesting,NinthEdition

24. ThedurationandmodifieddurationcanbecalculatedusingtheIMDsoftware.Itgivestheprecise
durationmeasurebecauseitavoidstheroundingofferrorswhichareinevitablewithmanual
calculations.ThefollowinganswersarecomputedusingaLotus123worksheetsetuptomimic
manualcalculationsusingpresentvaluefactorsfromtableB.3.Thedurationandmodifiedduration
measuresusingIMDareprovidedforcomparison.
(a) Durationandmodifiedduration
T
[PV(Ct ) t ]
Duration

Pbond
t 1
Modifiedduration

Durationinyears
1 Yieldtomaturity

Bond1:13years,8,pricedtoyield7.47%
UsingLotus123,durationofthisbondis8.74.years
8.74
8.13
1 0.0747
Usingthesoftwarethedurationis8.58yearsandthemodifieddurationis7.97%.
Modifiedduration

Bond2:15years, 7 7/8 ,pricedtoyield7.60%

UsingLotus123,durationofthisbondis9.41.years
9.41
8.75
1 0.0760
Usingthesoftwarethedurationis9.37yearsandthemodifieddurationis8.71%
Modifiedduration

Bond3:20years,zerocoupon,pricedtoyield8.22%
Withazerocouponbond,thedurationofthisbondisthesameasitsmaturity,20years.
20.00
18.48
Modifiedduration
1 0.0822

Chapter11BondValuation220

Bond4:24years,7,pricedtoyield7.90%
UsingLotus123,durationofthisbondis11.59.years
11.59
10.70
Modifiedduration
1 0.0790
Usingthesoftwarethedurationis11.56yearsandthemodifieddurationis10.72%
(b) WhenElliotinvests$250,000ineachofthefourbonds,theweightedaveragedurationofthe
portfoliois:
(1)

(2)

(3)

Bond1
Bond2
Bond3
Bond4

Bond
Particulars
13years,8.15%
15years,7.875%
20years,0%
24years,7.5%

Amount
Invested
$250,000
250,000
250,000
250,000
$1,000,000

(4)
Weight
0.25
0.25
0.25
0.25
1.00

(5)
Bond
Duration
8.74
9.41
20.00
11.59

(6)
Weighted
Duration
(4)(5)
2.1850
2.3525
5.0000
2.8975
12.4350

Thedurationoftheportfoliois12.44years.
(c) WhenElliotinvests$360,000eachintobonds1and3,and$140,000eachintobonds2and4,the
weightedaveragedurationofthebondportfoliois:
(1)

(2)

Bond1
Bond2
Bond3
Bond4

Bond
Particulars
13years,8.25%
15years,7.875%
20years,0%
24years,7.5%

(3)
Amount
Invested
$360,000
140,000
360,000
140,000
$1,000,000

(4)
Weight
0.36
0.14
0.36
0.14
1.00

(5)
Bond
Duration
8.74
9.41
20.00
11.59

(6)
Weighted
Duration
(4)(5)
3.1464
1.3174
7.2000
1.6226
13.2864

Thedurationoftheportfoliois13.29years.
(d) Portfolio(c)hasahigherdurationthanportfolio(b).Ifratesareabouttorise,thenitissaferto
investinportfolio(b),becausethiswouldbelesspricevolatilethantheotherportfolio.

.8

Solutions to Case Problems

Case 11.1The Bond Investment Decisions of Kelley and Erin Coates

Inthiscase,thestudentisaskedtoevaluatetwobondtradingopportunitiesoneinvolvesusingbondsto
speculateonshortterminterestratemovements,andtheotherdealswithabondswap.
(a) 1. TheCoatesareattemptingtospeculateoninterestratesbyseekingcapitalgainsfromanexpected
dropinrates.

221Gitman/JoehnkFundamentalsofInvesting,NinthEdition

2. Thepriceofthebondin2years(whenithas23yearstomaturity):
Priceofbond Coupon(PVIFA)Maturityvalue(PVIF)
$75PVIFA8%,23yrs.$1,000PVIF8%,23yrs.
$7510.371$1,0000.170
$778$170948
3. Usingtheformulaforexpectedreturn
Currentprice:$852
CouponPayment:$75
Holdingperiod2years
FuturePrice$948
Letr%betheYieldToMaturity.Wehavethefollowing:
85275PVIFAr%,2period$948PVIFr%,2period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theYTM
is14%
4. Althoughthisappearstobeanattractiveinvestment,onemustcomparetheexpectedreturnwith
otherpossiblealternatives.Presumingtheexpectedrateofreturn(of14%)iscommensuratewith
theexposuretorisk,Kelley&Erinshouldseriouslyconsiderthisbondinvestmentopportunity
unlesstheyfeelstronglythattheycandobetterelsewhere.Further,theyshouldbewellawareof
thefactthatthishighrateofreturnisdueinlargeparttotheirabilitytocorrectlyforecastinterest
rates(noeasytask);theyshouldfullyappreciatetheimplicationsofthiskindofriskexposure.
(b) 1. Wewillevaluatethecurrentandpromisedyieldsusingthetextsformulas.
CurrentyieldAnnualinterest/Currentprice
BetaCorporation
$70/$785
8.92%

DentalFloss,Inc
$75/$780
9.60%

RootCanalProducts
$65/$885
7.35%

KansasCityDental
$80/$950
8.42%

Insurance
BetaCorporation:
78535PVIFAr%,30period$1,000PVIFr%,30period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:4.87%29.75%
DentalFloss,Inc:
78037.50PVIFAr%,30period$1,000PVIFr%,30period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:5.21%210.42%
RootCanalProducts:
88533.50PVIFAr%,26period$1,000PVIFr%,26period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:4%28%

Chapter11BondValuation222

KansasCityDentalInsurance:
95040PVIFAr%,34period$1,000PVIFr%,34period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:4.28%28.56%
2. Clearly,DentalFlossoffersbothhighercurrentandpromisedyieldsthanBetaCorporation.
3. TheCoatesshouldswapBetaforDentalFlosstoobtainhighercurrentincomeandpromised
yield;thispresumesthetwohaveequaldefaultrisk,andthattheCoatesaresurethetwoareof
comparablequality.

Case 11.2Grace Decides to Immunize Her Portfolio

(a) CurrentandPromisedYieldCalculations
Currentyield

Annualinterestincome
Currentmarketpriceofbond

Bond1:12years,7%coupon;currentlypricedat$895
Currentyield

$75
8.38%
$895

YieldtoMaturity:89575PVIFAr%,12period1,000PVIFr%,12period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:8.96%
Bond2:10years,zerocoupon;currentlypricedat$405
Currentyield0%forazerocouponbond
Preciseyield:SolveforPVIF:
$405 $1, 000 PVIF
$405
PVIF
0.405
$1, 000
The10yearfactorclosestto0.405(fromTableB.3)occurat9%(0.422)and10%(0.386).Because
0.405ishalfwaybetweenthetwo,thepromisedyieldonthissecurityshouldbe9.5%.
Usingthesoftware,theYTMis9.45%.
Bond3:10years,10%coupon;currentlypricedat$1,080
Currentyield

$100
9.26%
$1,080

YieldtoMaturity:1,080100PVIFAr%,10period1,000PVIFr%,10period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:8.77%

223Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Bond4:15years,9%coupon;currentlypricedat$980
Currentyield

$97.50
9.95%
$980.00

YieldtoMaturity:98097.50PVIFAr%,15period1,000PVIFr%,15period
Ther%canbecalculatedbytrialanderrorusingTables.Usingafinancialcalculator,theexpected
returnis:10%
(b) DurationandPriceVolatility
Bond1:12years,7%coupon;currentlypricedat$895toyield9%
UsingLotus123,durationofthisbondis8.07years
8.07
7.40
1 0.09
Percentchangeinbondprice1ModifieddurationChangeininterestrate
Modifiedduration

17.400.75
5.55%
Thepriceofthebondwillfallby5.55%ifinterestraterise0.75%andviceversa.
Bond2:10years,zerocoupon;currentlypricedat$405toyield9.5%
Thedurationofazerocouponbondisthesameasitsmaturity,or10years.
Modifiedduration

10.00
9.13
1 0.095

Percentchangeinbondprice1ModifieddurationChangeininterestrate
19.130.75
6.85%
Thepriceofthebondwillfallby6.85%ifinterestraterise0.75%andviceversa.
Bond3:10years,10%coupon;currentlypricedat$1,080toyield8.75%
UsingLotus123,durationofthisbondis6.89years.
Modifiedduration

6.89
6.34%
1 0.0875

Percentchangeinbondprice1ModifieddurationChangeininterestrate
16.340.75
4.76%
Thepriceofthebondwillfallby4.76%ifinterestraterise0.75%andviceversa.

Chapter11BondValuation224

Bond4:15years,9%coupon;currentlypricedat$980toyield10%
UsingLotus123,durationofthisbondis8.41years.
8.41
7.65%
1 0.10
Percentchangeinbondprice1ModifieddurationChangeininterestrate
1.650.75
5.74%
Modifiedduration

Thepriceofthebondwillfallby5.74%ifinterestraterise0.75%andviceversa.
(c) WhenGraceinvests450,000ineachofthefourbonds,theweightedaveragedurationofthebond
portfoliowouldbe:
(1)

Bond1
Bond2
Bond3
Bond4

(2)
Bond
Particulars
12years,7.50%
10years,zero
10years,10%
15years,9.75%

(3)

(4)

Amount
Invested
$50,000
50,000
50,000
50,000
$200,000

Weight
0.25
0.25
0.25
0.25
1.00

(5)
Bond
Duration
8.07
10.00
6.89
8.41

(6)
Weighted
Duration
(4)(5)
2.0175
2.5000
1.7225
2.1025
8.3425

Thedurationoftheportfoliois8.34years.Gracesinvestmenthorizonis7years;therefore,thebond
portfolioisnotimmunizedbecausetheweightedaverageoftheportfolioisgreaterthantheinvestment
horizon.
(d) Thebondwiththehighestdurationisthezerocouponbond(10years).Thebondwiththelowest
durationisthe10%,10yearbond.Tolengthentheportfoliosduration,Gracecaninvestinhigher
durationbondsandshortenthedurationbyinvestinginlowerdurationbonds.Byinvestingtheentire
sumof$200,000inthe10yearbond,shecanachievetheshortestdurationportfolio.Obviously,
investingtheentireportfoliointhezerocouponbondresultsinthelongestdurationportfolio.
(e) Graceisplanningtocashoutofthebondportfolioinabout7yearsandwantstoimmunizethe
portfolio.Todoso,wemustfindaportfoliowithaweightedaveragedurationof7years.Theeasiest
waytoimmunizeherportfoliofrominterestrateriskistoinvestallofthe$200,000inthe10year,
10%bond,withits6.89yearduration.
Toachieveafullyimmunizedportfoliowithadurationofexactly7years,wecanconsiderthe12
year,7.50%bondwithits8.07yeardurationandthe10year,10%bondwithits6.89yearduration.
Thefollowingportfoliohasa7.01yeardurationandisthereforeimmunizedfrominterestraterisk:
(1)

Bond1
Bond2

(2)
Bond
Particulars
12years,7.50%
10years,10%

(3)
Amount
Invested
$20,000
180,000

(4)
Weight
0.10
0.90
1.00

(5)
Bond
Duration
8.07
6.89

(6)
Weighted
Duration
(4(5)
0.8070
6.2010
7.0080

225Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(f) RegardlessofhowGraceimmunizesherbondportfolio,immunizationisnotmeanttobeapassive
strategythatshecanputawayandforgetabout.Immunizationisacontinuedportfoliorebalancing
processthatreflectschangesinmarketinterestrates.

.9

Outside Project

Chapter 11RealizedReturnsonBondsvs.TheirPromisedYields
Whatkindofreturnshaveinvestorsearnedlately?Howdolastyearsrealizedreturnsstackupagainstthe
yields(i.e.,yieldstomaturity)promisedatthetimeofpurchase?Realizedreturnsonbondsareofinterest
toinvestorsbecausepastperformancemaygivecluestothecurrenttrendsandmaysuggestpossibletrend
shifts.Thepurposeofthisprojectistolookatholdingperiodreturnsforthepastyearonbonds.
ObtainaWallStreetJournalthatsapproximatelyoneyearold,andselectfourcorporatebondsthatare
tradedontheNewYorkStockExchange(makesuretheyrenonconvertible).Selectmaturitiesof5years,
10years,15years,and20years.Recordtheprices,coupons,andmaturitiesofyourfourbonds;also
determinethepromisedyieldforeachissue.Now,lookupthesamebondstoday.Calculatetheholding
periodreturnactuallyrealizedforeachsecurityoverthepastyear.Notetheeffectofcouponandmaturity
oneachbondsreturn.Contrastthepromisedyieldofeachbondwithitsrealizedreturn.Howdoyou
explainthedifference?