Solution to Handout #3

Part A

Value of Bond A:

PMT: 80

FV:1,000

N: 5

I/YR: 12%

PV: ?

The PV yields a value of $855.81 for Bond A

Value of Bond B:

PMT: 80

FV:1,000

N: 10

I/YR: 12%

PV: ?

The PV yields a value of $773.99 for Bond B

Value of Bond C:

PMT: 120

FV:1,000

N: 5

I/YR: 12%

PV: ?

The PV yields a value of $1,000.00 for Bond C

Part B

The total yield (yield to maturity) of a bond is comprised of the current yield (Interest/Price) and the capital gain yield:

For Bond A:

For Bond B:

For Bond C:

Part C

All three bonds need to be re-priced at the new interest rate of 8%. You should know that since the market rate of interest now equals the coupon rate of interest on Bonds A and B, their market prices should be the same as par.

Value of Bond A:

PMT: 80

FV:1,000

N: 5

I/YR: 8%

PV: ?

The PV at 8% yields a value of $1,000.00 for Bond A. Thus, the drop in interest rates from 12% to 8% caused the value of Bond A to increase from $855.81 to $1,000 or a gain of $144.19 on the bond. As a percentage of its initial value of $855.81 this amounts to a 16.85% increase in price

Value of Bond B:

PMT: 80

FV:1,000

N: 10

I/YR: 8%

PV: ?

The PV at 8% yields a value of $1,000.00 for Bond B. The drop in interest rates from 12% to 8% caused the value of Bond B to increase from $773.99 to $1,000 or a gain of $226.01 on the bond. As a percentage of its initial value of $773.99 this amounts to a 29.2% increase in price

Value of Bond C:

PMT: 120

FV:1,000

N: 5

I/YR: 8%

PV: ?

The PV at 8% yields a value of $1,159.71 for Bond C. The drop in interest rates from 12% to 8% caused the value of Bond C to increase from $1,000.00 to $1,159.71 or a gain of $159.71 on the bond. As a percentage of its initial value of $1,000.00 this amounts to a 15.97% increase in price

Thus, lower coupon and longer-lived bonds are more sensitive to changes in interest rates.