BASFIN1 TUTORIAL 4
Conducted by Dr. Dulani Jayasuriya, January 2016
Review
Assessing an asset’s value today requires
discounting its expected future cash flows to the
present.
Review
The yield-to-maturity (YTM) is that yield which
equates the present value of all the cash flows from
a bond to the price of a bond. Yield-to-maturity is
the rate implied by the current bond price
Coupon Rate & YTM: Annual Rate
Review
It is a Time Value problem!!
Five Factors: PV, FV, r, N, PMT
Question 1
Bond X is a premium bond making annual payments.
The bond pays an 8% coupon, has a YTM of 6% and
has 13 years to maturity. Bond Y is a discount bond
making annual payments. This bond pays a 6% coupon,
has a YTM of 8%, and also has 13 years to maturity. If
the interest rates remain unchanged, what do you expect
the price of these bonds to be one year from now? In
three years? In eight years? In 12 years? In 13 years?
What’s going on here? Illustrate your answers by
graphing bond prices versus time to maturity.
Question 2
Both Bond Sam and Bond Dave have 9 percent coupons, make
semiannual payments, and are priced at par value. Bond Sam
has 3 years to maturity, whereas Bond Dave has 20 years to
maturity. If the interest rates suddenly rise by 2 percent, what is
the percentage change in the price of Bond Sam? Of Bond
Dave? If the rates were to suddenly fall by 2 percent instead,
what would the percentage change in the price of Bond Sam be
then? Of Bond Dave?
Illustrate your answers by graphing bond prices versus YTM.
What does this problem tell you about the interest rate risk of
longer maturity bond?
Question 3
Bond J is a 4 percent coupon bond; Bond K is a 12 percent
coupon bond. Both bonds have nine years to maturity,
make semiannual payments, and have a YTM of 8 percent.
If interest rates suddenly rise by 2 percent, what is the
percentage change of these bonds?
What if rates suddenly fall by 2% instead? What does this
problem tell you about the interest rate risk of lower-
coupon bonds?
Question 4
The YTM on a bond is the interest rate you earn on your investment if
interest rates don’t change. If you actually sell the bond before it
matures, your realised return is known as the holding period yield
(HPY).
a. Suppose that today you buy a 7 percent annual coupon bond for
$1,060. The bond has 10 years to maturity. What rate of return do
you expect to earn on your investment?
b. Two years from now, the YTM on your bond has declined by 1
percent, and you decided to sell. What price will your bond sell for?
What is the HPY on your investment? Compare this yield to the YTM
when you first bought the bond. Why are they different?
Review
1. “Pull to Par”: price converges to par value at
maturity
2. Longer maturity, greater sensitivity to interest rate,
all else the same
3. Lower coupon rate, greater sensitivity to interest
rate, all else the same
•Bonds vary according to characteristics such as the type of issuer, priority,
coupon rate, and redemption features.
•Bond prices may be either dirty or clean, depending on when the last coupon
payment was made and how much interest has been accrued.
•Yield is a measure of the income an investor receives if he or she holds a
bond until maturity; required yield is the minimum income a bond must offer
in order to attract investors.
•Current yield is a basic calculation of the annual percentage return an
investor receives from his or her initial investment.
•Yield to maturity is the resulting interest rate an investor receives if he or she
invests all coupon payments at a constant interest rate until the bond matures.
•The term structure of interest rates, or yield curve, is useful in determining
the direction of market interest rates.
•The yield curve demonstrates the concept of the credit spread between
corporate and government fixed income securities.
