Chapter 12 HW Solution.docx

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Mishkin/Eakins •  Financial Markets Markets and Institutions, Institutions, Seventh Edition

Chapter 12 The Bond Market 

Answers

to

End-of-Chapter 

Questions 1. Investors use capital markets for long-term investment purposes. purposes. They They use money money markets !hich !hich have lo!er yields primarily for temporary or transaction purposes. ". The primary capital capital market securities securities are stocks stocks and #onds. #onds. Most of of these are purchased and o!ned  #y households. $. The primary market is for securities #eing #eing issued for the very first time time and the issuer receives the funds paid for the security. The secondary market is for securities that have #een issued previously  #ut are #eing traded among investors. investors. %. The par value is the amount the issuer issuer !ill pay the the holder !hen the #ond matures. matures. The coupon interest interest rate is multiplied times the par value to determine the interest payment the issuer must make each year. The maturity date is !hen the issuer must pay the holder the par value. &. Treasury #ills #ills mature in less than 1 year Treasury notes notes mature in 1 to 1' years and Treasury #onds mature in 1' to $' years. (. The risk that a #ond)s price price !ill change due to changes in market market interest rates is called interest rate risk. *. +gencies that issue securities securities include ,innie ,innie Mae formerly the the ,overnment ational ational Mortgage Mortgage +ssociation the 0ederal ousing +dministration +dministration the 2eterans 2eterans +dministration the 0ederal ational Mortgage +ssociation +ssociation and the Student 3oan Marketing +ssociation. The first four fund mortgage loans and the last funds college student loans. 4. 0irms like having having the fle5i#ility fle5i#ility to ad6ust ad6ust their capital structure #y paying paying off de#t de#t they no longer  longer  need. They also need to pay off de#t to remove restrictive covenants. 7all provisions permit #oth these actions at the issuer)s discretion. 8. + sinking sinking fund contains funds set aside aside #y the issuer issuer of a #ond to pay pay for the redemption redemption of the #ond #ond !hen it matures. 9ecause a sinking fund increases the likelihood that a firm !ill have the funds to  pay off the #onds as re:uired re:uired investors like the feature. +s a result interest rates are lo!er on securities !ith sinking funds. 1'. The list of terms of a #ond is kno!n as the indenture. indenture. 11. 7apital market securities securities may #e sold in a pu#lic offering or in a private placement. placement. In a pu#lic offering investment #ankers register the security !ith the SE7 and market it through a net!ork of  #rokerage houses. In a private placement placement the firm or an investment #anker sells the securities to a very limited num#er of investors !ho each #uy a large :uantity. :uantity.

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Quantitative Problems

1. + #ond pays ;4' per year in interest 4< coupon. The #ond has & years #efore it matures at !hich time it !ill pay ;1'''. +ssuming a discount rate of 1' Solution: ;8"%.14

". + ?ero coupon #ond has a par value of ;1''' and matures in "' years. Investors re:uire a 1'< annual return on these #onds. 0or !hat price should the #ond sell> ote@ Aero coupon #onds do not  pay any interest. =evie! 7hapter $> Solution: ;1%4.(%

$. 7onsider the t!o #onds descri#ed #elo!@

Maturity 7oupon =ate Baid semiannually Bar 2alue

Bond A

Bond B

1& yrs

"' yrs

1'<

(<

;1'''

;1'''

a. If #oth #onds had a re:uired return of 4  #. Cescri#e !hat it means if a #ond sells at a discount a premium and at its face amount par value. +re these t!o #onds selling at a discount premium or par> c. If the re:uired return on the t!o #onds rose to 1' Solution:

a.  #. c.

9ond + = ;11*".8" 9ond 9 = ;4'".'* 9ond + is selling at a premium 9ond 9 is selling at a discount 9ond + = ;1''' 9ond 9 = ;(&(.4"

%. + "-year ;1''' par ?ero-coupon #ond is currently priced at ;418.''. + "-year ;1''' annuity is currently priced at ;1*1".&". If you !ant to invest ;1'''' in one of the t!o securities !hich is a  #etter #uy> Dou can assume a. the pure e5pectations theory of interest rates holds  #. neither #ond has any default risk maturity premium or li:uidity premium and c. you can purchase partial #onds. Solution: ith PV = ;418F FV = ;1'''F PMT = 'F and N = " the yield to maturity on the t!o-year ?ero-coupon #onds is 1'.&< for the t!o-year annuities.  PV = ;1*1".&"F PMT = 'F  FV = ;"'''F and  N = " gives a yield to maturity of 4.'* Solution:

a.

Short "' shares of MHE at ;&"/share.

;1 '%*' I

;1'.$&

 #. Burchase a converti#le #ond. c.

7ash

;&

7onvert the #ond to shares and use to close short position.

+ssuming these transactions are completed simultaneously you make a riskless profit of ;&. Typically small investors cannot short stock and have use of the proceedsJthe #roker retains it as collateral. So this doesn)t :uite !ork. 9ut the idea is correct. 1'. + 1'-year 1''' par value #ond !ith a &< annual coupon is trading to yield ( Solution: The current price of the #ond is computed as follo!s@  PMT = &'F  N = 1'F  FV = 1'''F I = ( 7ompute PV F PV = 8"(.%' The current yield = &'/8"(.%' = &.%<

11. + ;1''' par #ond !ith an annual coupon has only 1 year until maturity. Its current yield is (.*1$< and its yield to maturity is 1' Solution: a. CY = '.'(*1$ = 7oupon/Brice or 7oupon = '.'(*1$ × Brice

 #. Brice = 7oupon + 1'''/1.1'. Su#stituting from 1 Brice = '.'(*1$ × Brice + 1'''/1.1' Solve for priceF Brice = ;8(4.1* 1". + 1-year discount #ond !ith a face value of ;1''' !as purchased for ;8''. hat is the yield to maturity> hat is the yield on a discount #asis> Solution: 8'' = 1'''/1 + DTM or

DC9 = 1''' K 8''/1'''

×

DTM = 11.11< $('/$(& = 8.4(<

1$. + *-year ;1''' par #ond has an 4< annual coupon and is currently yielding *.&