Mini Case Ch5

Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance Company and co-directors of the companys pension fund management division. An important new client, the North-Western Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions.

e. (1) What would be the value of the bond described in Part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13% return? Would we now have a discount or a premium bond? (2) What would happen to the bonds value if inflation fell and rd declined to 7%? Would we now have a premium or a discount bond? (3) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13%? If it remained at 7%? (Hint: With a financial calculator, enter PMT, I/YR, FV, and N, and then change N to see what happens to the PV as the bond approaches maturity.)

f. (1) What is the yield to maturity on a 10-year, 9% annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bonds coupon rate? (2) What is the total return, the current yield, and the capital gains yield for the discount bond? (Assume the bond is held to maturity and the company does not default on the bond.)

g. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10% coupon bond if the nominal rd 13%.

m. What is interest rate (or price) risk? Which bond has more interest rate risk: an annual payment 1-year bond or a 10-year bond? Why?