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# A B C D E F G

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3 Chapter 5. Mini Case
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5 Situation
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Sam Strother and Shawna Tibbs are vice-presidents of Mutual of Seattle Insurance Company and co-directors of the company's
7 pension fund management division. A major new client, the Northwestern Municipal Alliance, has requested that Mutual of
8 Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual
9 presentation, have asked you to help them by answering the following questions. Because the Boeing Company operates in one
10 of the league's cities, you are to work Boeing into the presentation.
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12 a. What are the key features of a bond? Answer: See Chapter 5 Mini Case Show
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14 b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?
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16 Call Provisions and Sinking Funds
17 A call provision that allows the issuer to redeem the bond at a specified time before the maturity date. If interest rates fall, the
18 issuer can refund the bonds and issue new bonds at a lower rate. Because of this, borrowers are willing to pay more and lenders
19 require more on callable bonds.
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21 In a sinking fund provision, the issuer pays off the loan over its life rather than all at the maturity date. A sinking fund reduces
22 the risk to the investor and shortens the maturity. This is not good for investors if rates fall after issuance.
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24 c. How is the value of any asset whose value is based on expected future cash flows determined? Answer: See Chapter 5 Mini
25 Case Show
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27 d. How is the value of a bond determined? What is the value of a 10-year, \$1,000 par value bond with a 10 percent annual
28 coupon if its required rate of return is 10 percent?
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30 Finding the "Fair Value" of a Bond
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32 First, we list the key features of the bond as "model inputs":
33 Years to Mat: 10
34 Coupon rate: 10%
35 Annual Pmt: \$100
36 Par value = FV: \$1,000
37 Going rate, rd: 10%
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39 The easiest way to solve this problem is to use Excel's PV function. Click fx, then financial, then PV. Then fill in the menu items
40 as shown in our snapshot in the screen shown just below.
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A B C D E F G
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60 Value of bond = \$1,000.00 Thus, this bond sells at its par value. That situation always exists if the going rate is equal to the
61 coupon rate.
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63 The PV function can only be used if the payments are constant, but that is normally the case for bonds.
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65 e. (1.) What would be the value of the bond described in Part d if, just after it had been issued, the expected inflation rate rose by
66 3 percentage points, causing investors to require a 13 percent return? Would we now have a discount or a premium bond?
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69 We could simply go to the input data section shown above, change the value for r from 10% to 13%. You can set up a data table
70 to show the bond's value at a range of rates, i.e., to show the bond's sensitivity to changes in interest rates. This is done below.
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72 Bond Value
To make the data table, first type the headings, then type the rates in cells in the left
73 Going rate, r: \$1,000 column. Since the input values are listed down a column, type the formula in the
74 0% row above the first value and one cell to the right of the column of values (this is
75 7% B73; note that the formula in B73 actually just refers to the bond pricing formula
above in B58). Select the range of cells that contains the formulas and values you
76 10%
want to substitute (A73:B78). Then click Data, What-If-Analysis, and then Data
77 13% Table to get the menu. The input data are in a column, so put the cursor on
78 20% "column input cell" and enter the cell with the value for r (B37), then Click OK to
79 complete the operation and get the table.
80 We can use the data table to construct a graph that shows
81 the bond's sensitivity to changing rates.
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84 Inte re st Rate Se nsitivity of a 10-Year Bond
85 Value at 7% Value at 13%
86 \$12
87 \$10
\$8
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\$6
89 \$4
90 \$2
91 \$0 Put B37 here.
92 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
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96 (2.) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent, or if
97 it remained at 7 percent? Would we now have a premium or a discount bond in either situation? You pick a rate.
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A B C D E F G
99 Value of Bond in Given Year:
100 N 7% 10% 13%
101 0 \$1,211 \$1,000 \$837
102 1 \$1,195 \$1,000 \$846
103 2 \$1,179 \$1,000 \$856
104 3 \$1,162 \$1,000 \$867
105 4 \$1,143 \$1,000 \$880
106 5 \$1,123 \$1,000 \$894
107 6 \$1,102 \$1,000 \$911
108 7 \$1,079 \$1,000 \$929
109 8 \$1,054 \$1,000 \$950
110 9 \$1,028 \$1,000 \$973
111 10 \$1,000 \$1,000 \$1,000
112 You pick the rate for a bond:
113 Rates fall to 7%
Value of the bond over time Rates stay the same
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115 Rates increase to 13%
\$1,400
117 Resulting bond prices
118 \$1,200
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120 \$1,000
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122 Price \$800
123 \$600
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125 \$400
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127 \$200
128 \$0
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1 2 3 4 5 6 7 8 9 10 11
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Years to maturity
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134 If rates fall, the bond goes to a premium, but it moves towards par as maturity approaches. The reverse hold if rates rise and the
135 bond sells at a discount. If the going rate remains equal to the coupon rate, the bond will continue to sell at par. Note that the
136 above graph assumes that interest rates stay constant after the initial change. That is most unlikely--interest rates fluctuate, and
137 so do the prices of outstanding bonds.
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139 Yield to Maturity (YTM)
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141 f. (1.) What is the yield to maturity on a 10-year, 9 percent annual coupon, \$1,000 par value bond that sells for \$887.00? That
142 sells for \$1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between r d
143 and the bond's coupon rate? What is the yield-to-maturity of the bond?
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145 Use the Rate function to solve the problem.
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147 Years to Mat: 10
A B C D E F G
148 Coupon rate: 9%
149 Annual Pmt: \$90.00 Going rate, r =YTM: 10.91% See RATE function at right
150 Current price: \$887.00
151 Par value = FV: \$1,000.00
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153 (2.) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to
154 maturity and the company does not default on the bond.)
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156 Current and Capital Gains Yields
157 The current yield is the annual interest payment divided by the bond's current price. The current yield provides information
158 regarding the amount of cash income that a bond will generate in a given year. However, it does not account for any capital gains
159 or losses that will be realized if the bond is held to maturity or call.
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161 Simply divide the annual interest payment by the price of the bond. Even if the bond made semiannual payments, we would still
162 use the annual interest.
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164 Par value \$1,000.00
165 Coupon rate: 9% Current Yield = 10.15%
166 Annual Pmt: \$90.00
167 Current price: \$887.00
168 YTM: 10.91%
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170 The current yield provides information on a bond's cash return, but it gives no indication of the bond's total return. To see this,
171 consider a zero coupon bond. Since zeros pay no coupon, the current yield is zero because there is no interest income. However,
172 the zero appreciates through time, and its total return clearly exceeds zero.
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174 YTM = Current Yield + Capital Gains Yield
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177 Capital Gains Yield = YTM - Current Yield
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179 Capital Gains Yield = 10.91% - 10.15%
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181 Capital Gains Yield = 0.76%
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184 g. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual
185 payment, 10 percent coupon bond if nominal rd = 13%.
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187 Bonds with Semiannual Coupons
188 Since most bonds pay interest semiannually, we now look at the valuation of semiannual bonds. We must make three
189 modifications to our original valuation model: (1) divide the coupon payment by 2, (2) multiply the years to maturity by 2, and
190 (3) divide the nominal interest rate by 2.
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192 Use the Rate function with adjusted data to solve the problem.
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194 Periods to maturity = 10*2 = 20
195 Coupon rate: 10%
196 Semiannual pmt = \$100/2 = \$50.00 PV = \$834.72
A B C D E F G
197 Future Value: \$1,000.00
198 Periodic rate = 13%/2 = 6.5%
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200 Note that the bond is now more valuable, because interest payments come in faster.
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203 Excel Bond Functions
204 Supose today's date is January 1, 2010, and the bond matures on December 31, 2019
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206 Settlement (today) 1/1/2010
207 Maturity 12/31/2019
208 Coupon rate 10.00%
209 Going rate, r 13.00%
210 Redemption (par value) 100
211 Frequency (for semiannual) 2
212 Basis (360 or 365 day year) 0
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215 Value of bond = \$83.4737 or \$834.74
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217 Notice that you could choose a current date that is between coupon payments, and the PRICE function will calculate the correct
218 price. See the example below.
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221 Settlement (today) 3/25/2010
222 Maturity 12/31/2019
223 Coupon rate 10.00%
224 Going rate, r 13.00%
225 Redemption (par value) 100
226 Frequency (for semiannual) 2
227 Basis (360 or 365 day year) 0
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229 Value of bond = \$83.6307 or \$836.31
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231 This is the value of the bond, but it does not include the accrued interest you would pay. The ACCRINT function will calculate
232 accrued interest, as shown below.
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234 Issue date 1/1/2010
235 First interest date 6/30/2010
236 Settlement (today) 3/25/2010
237 Maturity 12/31/2019
238 Coupon rate 10.00%
239 Going rate, r 13.00%
240 Redemption (par value) 100
241 Frequency (for semiannual) 2
242 Basis (360 or 365 day year) 0
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244 Accrued interest = \$2.3333 or \$23.33
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A B C D E F G
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247 Suppose the bond's price is \$1,150. You can also calculate the yield using the YIELD function, as shown below.
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249 Curent price \$ 1,150.00
250 Settlement (today) 1/1/2010
251 Maturity 12/31/2019
252 Coupon rate 10.00%
253 Redemption (par value) 100
254 Frequency (for semiannual) 2
255 Basis (360 or 365 day year) 0
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257 Yield 7.81%
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260 h. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of \$1,000 is currently selling for \$1,135.90, producing
261 a nominal yield to maturity of 8 percent. However, the bond can be called after 5 years for a price of \$1,050.
262 (1.) What is the bond's nominal yield to call (YTC)?
263 (2.) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why?
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265 Yield to Call
266 The yield to call is the rate of return investors will receive if their bonds are called. If the issuer has the right to call the bonds,
267 and if interest rates fall, then it would be logical for the issuer to call the bonds and replace them with new bonds that carry a
268 lower coupon. The yield to call (YTC) is found similarly to the YTM. The same formula is used, but years to maturity is replaced
269 with years to call, and the maturity value is replaced with the call price.
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271 Use the Rate function to solve the problem.
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273 Number of semiannual periods to call: 10
274 Seminannual coupon rate: 5% Semiannual Rate = I = YTC =
275 Seminannual Pmt: \$50.00 Annual nominal rate =
276 Current price: \$1,135.90
277 Call price = FV \$1,050.00
278 Par value \$1,000.00
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281 i. Write a general expression for the yield on any debt security (rd) and define these terms: real risk-free rate of interest (r*),
282 inflation premium (IP), default risk premium (DRP), liquidity premium (LP), and maturity risk premium (MRP). Answer: See
283 Chapter 5 Mini Case Show.
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286 j. Define the nominal risk-free rate (rRF). What security can be used as an estimate of rRF? Answer: See Chapter 5 Mini Case
287 Show.
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290 k. Describe a way to estimate the inflation premium (IP) for a T-Year bond. Answer: See Chapter 5 Mini Case Show.
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293 l. What is a bond spread and how is it related to the default risk premium? How are bond ratings related to default risk? What
294 factors affect a companys bond rating? Answer: See Chapter 5 Mini Case Show.
A B C D E F G
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297 m. What is interest rate (or price) risk? Which bond has more interest rate risk, an annual payment 1-year bond or a 30-year
298 bond? Why?
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301 Interest Rate Risk is the risk of a decline in a bond's price due to an increase in interest rates. Price sensitivity to interest rates is
302 greater (1) the longer the maturity and (2) the smaller the coupon payment. Thus, if two bonds have the same coupon, the bond
303 with the longer maturity will have more interest rate sensitivity, and if two bonds have the same maturity, the one with the
304 smaller coupon payment will have more interest rate sensitivity.
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308 Your Choice of Maturity 10-Yr Maturity
309 Years to Mat: 10 Rate Price Rate Price
310 Coupon rate: 9% \$929.60 \$887.63
311 Annual Pmt: \$90.00 5.0% 5.0%
312 Current price: \$887.63 7.0% 7.0%
313 Par value = FV: \$1,000.00 9.0% 9.0%
314 YTM = 10.9% 11.0% 11.0%
315 13.0% 13.0%
316 Years to Mat: 1
317 Coupon rate: 9% Column I
318 Annual Pmt: \$90.00 10 Yr. versus 1 Yr. Column G

## 320 Par value = FV: \$1,000.00

\$1,300.00
321 YTM = 10.9%
322 \$1,200.00

323 \$1,100.00
324 Enter your \$1,000.00
325 choice for years
\$900.00
326 to maturity: 5
327 \$800.00
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\$700.00
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330 5.0% 7.0% 9.0% 11.0% 13.0%
YTM
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335 n. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond? Answer: See
336 Chapter 5 Mini Case Show.
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339 o. How are interest rate risk and reinvestment rate risk related to the maturity risk premium? Answer: See Chapter 5 Mini
340 Case Show.
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343 p. What is the term structure of interest rates? What is a yield curve?
A B C D E F G
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345 The term structure describes the relationship between long-term and short-term interest rates. Graphically, this relationship can
346 be shown in what is known as the yield curve. See the hypothetical curve below.
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349 Hypothetical Inputs See to right for actual date used in graph
350 Real risk free rate 3.00%
351 Expected inflation of 5% for the next 1 years.
352 Expected inflation of 6% for the next 1 years.
353 Expected inflation of 8% thereafter.
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Hypothetical Treasury Yield Curve
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358 14.00%
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360 12.00% M RP

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362 10.00%
Interest Rate Inflation
363 Pre m iu
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8.00% m

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6.00%
367 Real Ris k
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4.00% Free Rate

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2.00%
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0.00%
373 1 2 3 4 5 6 7 8 9 1011121314151617181920
374 Maturity
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378 The yield is upward sloping due to increasing expected inflation and an increasing maturity risk premium
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381 q. Briefly describe bankruptcy law. If a firm were to default on the bonds, would the company be immediately liquidated?
382 Would the bondholders be assured of receiving all of their promised payments? Answer: See Chapter 5 Mini Case Show.
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