FINA 210 Lecture Notes - Lecture 2: Effective Interest Rate
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For this problem, assume you have been asked to evaluate investing some excess cash into the bond described below. When complete, recommend purchasing or looking at another option. Defend your recommendation by explaining the items you calculated.
A 20-year, 5.75% semiannual coupon bond with a par value of $1,000 may be called in 5 years at a call price of $1,060. The bond sells for $1,010. (Assume that the bond has just been issued.)
| Basic Input Data | |
|---|---|
| Years to Maturity: | 20 |
| Periods Per Year: | 2 |
| Periods to Maturity: | ______ |
| Coupon Rate: | 5.75% |
| Par Value: | $1,000 |
| Periodic Payment: | ______ |
| Current Price: | $1,010 |
| Call Price: | $1,060 |
| Years till Callable: | 5 |
| Periods till Callable: | ______ |
a. What is the bond's yeild to maturity?
| Periodic YTM = | ______ |
| Annualized Nominal YTM = | ______ |
Hint: This is a nominal rate, not the effective rate. Nominal rates are generally quoted.
b. What is the bond's current yeild?
| Current Yield = | ______ | Hint: Write formula in words. | |
| Current Yield = | / | ______ | Hint: Cell formulas should refer to Basic Input Data Section |
| Current Yield = | (Answer) |
c. What is the bond's yield to call?
Here we can again use the Rate function, but with data related to the call.
| Peridodic YTC = | ______ | |
| Annualized Nominal YTC = | ______ | This is a nominal rate, not effective rate. Nominal rates are generally quoted. |
When the YTC is lower than the YTM and if the bond is called, the buyer will lose the difference between the call price and the current price between the purchase date and the call date, and that loss would offset much of the interest income. Note too that if the YTC is lower than the YTM then the bond is likely to be called and replaced, hence that the YTC would probably be earned.
e. How would the price of the bond be affected by changing the going market interest rate? (Hint: Conduct a sensitivity analysis of price to changes in the going market interest rate for the bond. Assume that the bond will be called if and only if the going rate of interest falls below the coupon rate. That is an oversimplification, but assume it anyway for purposes of this problem.)
| Nominal market rate, r: | 6% |
| Value of bond if it's not called: | ______ |
| Value of bond if it's called: | ______ |
