ROBERT BLACK AND CAROL ALVAREZ ARE VICE-PRESIDENTS OF WESTERN MONEY
MANAGEMENT AND CODIRECTORS OF THE COMPANY’S PENSION FUND MANAGEMENT
DIVISION. A MAJOR NEW CLIENT, THE CALIFORNIA LEAGUE OF CITIES, HAS
REQUESTED THAT WESTERN PRESENT AN INVESTMENT SEMINAR TO THE MAYORS OF
THE REPRESENTED CITIES, AND BLACK AND ALVAREZ, WHO WILL MAKE THE ACTUAL
PRESENTATION, HAVE ASKED YOU TO HELP THEM BY ANSWERING THE FOLLOWING
QUESTIONS.
A. WHAT ARE THE KEY FEATURES OF A BOND?
B. WHAT ARE CALL PROVISIONS AND SINKING FUND
PROVISIONS? DO THESE PROVISIONS MAKE BONDS MORE OR LESS RISKY?
C. HOW IS THE VALUE OF ANY ASSET WHOSE VALUE IS BASED ON EXPECTED FUTURE CASH FLOWS DETERMINED?
D. HOW IS THE VALUE OF A BOND DETERMINED?
WHAT IS THE VALUE OF A 10-YEAR, $1,000 PAR VALUE BOND WITH A 10 PERCENT
ANNUAL COUPON IF ITS REQUIRED RATE OF RETURN IS 10 PERCENT?
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 PERCENT RETURN?
WOULD WE NOW HAVE A DISCOUNT OR A PREMIUM BOND?
2. WHAT WOULD HAPPEN TO THE BOND’S VALUE IF INFLATION FELL,
AND kd DECLINED TO 7 PERCENT? 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 PERCENT, OR IF IT
REMAINED AT
F.
1. WHAT IS THE YIELD TO MATURITY ON A 10-YEAR, 9 PERCENT
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 kd AND THE BOND’S
COUPON RATE?
2. WHAT ARE 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. 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?
H. WHAT IS REINVESTMENT RATE RISK? WHICH
HAS MORE REINVESTMENT RATE RISK, A 1-YEAR BOND OR A 10-YEAR BOND?
I. HOW DOES THE EQUATION FOR VALUING A BOND
CHANGE IF SEMIANNUAL PAYMENTS ARE MADE? FIND THE VALUE OF A 10-YEAR,
SEMIANNUAL PAYMENT, 10 PERCENT COUPON BOND IF NOMINAL kd = 13%.
J. SUPPOSE YOU COULD BUY, FOR $1,000,
EITHER A 10 PERCENT, 10-YEAR, ANNUAL PAYMENT BOND OR A 10 PERCENT,
10-YEAR, SEMIANNUAL PAYMENT BOND. THEY ARE EQUALLY RISKY. WHICH WOULD
YOU PREFER? IF $1,000 IS THE PROPER PRICE FOR THE SEMIANNUAL BOND, WHAT
IS THE EQUILIBRIUM PRICE FOR THE ANNUAL PAYMENT BOND?
K.
1. SUPPOSE A 10-YEAR, 10 PERCENT, SEMIANNUAL COUPON BOND
WITH A PAR VALUE OF $1,000 IS CURRENTLY SELLING FOR $1,135.90, PRODUCING
A NOMINAL YIELD TO MATURITY OF 8 PERCENT. HOWEVER, THE BOND CAN BE
CALLED AFTER
2. IF YOU BOUGHT THIS BOND, DO YOU THINK YOU WOULD BE MORE LIKELY TO EARN THE YTM OR THE YTC? WHY?
L. DOES THE YIELD TO MATURITY REPRESENT THE PROMISED OR EXPECTED RETURN ON THE BOND?
M. THESE BONDS WERE RATED AA- BY S&P.
WOULD YOU CONSIDER THESE BONDS INVESTMENT GRADE OR JUNK BONDS?
N. WHAT FACTORS DETERMINE A COMPANY’S BOND RATING?
O. IF THIS FIRM WERE TO DEFAULT ON THE BONDS,
WOULD THE COMPANY BE IMMEDIATELY LIQUIDATED? WOULD THE BONDHOLDERS BE
ASSURED OF RECEIVING ALL OF THEIR PROMISED PAYMENTS?
