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ADM 2337 Lecture Notes - Lecture 2: Callable Bond, Risk Premium, Capital Asset Pricing Model

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School
University of Ottawa
Department
Administration
Course
ADM 2337
Professor
Catherine Elliott

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Document Summary

If the bond can be called at moment s at call price and coupon is annual we can define yield. To call (ytc) as a rate that satisfies (*): Example 7: you"ve just bought a 4% coupon 15 year bond with annual coupon payments. This bond is callable in 7 years at a call price of . Find its yield to call (ytc) if your purchasing price was . Solution: , so, to nd ytc we need to use either a nancial calculator or an approximation formula. Example 8: today you found that your 15 year disney callable bond that can be called in 5 years at a price of has ytm =6% and ytc=7%. Solution: disney will end up paying its debtholders 6% if the bond is not retired. They would not want to pay 7%, so, the bond will not be called

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Related Questions

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: 40
Coupon Rate: 5.75%
Par Value: $1,000
Periodic Payment: $28.75
Current Price: $1,010
Call Price: $1,060
Years till Callable: 5
Periods till Callable: 10

Yield to Maturity

Periodic YTM = 3.27%
Annualized Nominal YTM = 6.55%

Current Yield

Current Yield = Annual Coupon Hint: Write formula in words.
Current Yield = / $58

Hint: Cell formulas should refer

to Basic Input Data Section
Current Yield = 0.0569

Yield to Call

Peridodic YTC = 2.91%
Annualized Nominal YTC = 5.83%

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.

Nominal market rate, r: 6%
Value of bond if it's not called: $971.11
Value of bond if it's called: $1,033.98

a. Assume you have been asked to evaluate investing some excess cash into the bond described above. Recommend purchasing the bond or looking at another option. Defend your recommendation by explaining the items above.

b. How would the price of the bond be affected by changing the going market interest rate?

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: ______

Yield to maturity and yield to call Kempton Enterprises has bonds outstanding with a $1,000 face value and 10 years left until maturity. They have an 12% annual coupon payment, and their current price is $1,175. The bonds may be called in 5 years at 109% of face value (Call price = $1,090).

What is the yield to maturity? Round your answer to two decimal places. %

What is the yield to call if they are called in 5 years? Round your answer to two decimal places. %

Which yield might investors expect to earn on these bonds? Why?

Investors would not expect the bonds to be called and to earn the YTM because the YTM is less than the YTC.

Investors would expect the bonds to be called and to earn the YTC because the YTC is less than the YTM. Investors would expect the bonds to be called and to earn the YTC because the YTM is less than the YTC.

Investors would expect the bonds to be called and to earn the YTC because the YTC is greater than the YTM.

Investors would not expect the bonds to be called and to earn the YTM because the YTM is greater than the YTC.

The bond's indenture indicates that the call provision gives the firm the right to call the bonds at the end of each year beginning in Year 5. In Year 5, the bonds may be called at 109% of face value; but in each of the next 4 years, the call percentage will decline by 1%. Thus, in Year 6, they may be called at 108% of face value; in Year 7, they may be called at 107% of face value; and so forth. If the yield curve is horizontal and interest rates remain at their current level, when is the latest that investors might expect the firm to call the bonds? Do not round intermediate calculations.