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10-2C

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Essentials Of Investments
Found in: Page 334
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

On May 30, 2009, Janice Kerr is considering the newly issued 10-year AAA corporate bonds shown in the following exhibit:

Description

Coupon

Price

Callable

Call Price

Sentinal due, May 30, 2019

6.00%

100

Non-callable

NA

Collina due, May 30, 2019

6.20%

100

Currently callabale

102

a. Suppose that market interest rates decline by 100 basis points (i.e., 1%). Contrast the effect of this decline on the price of each bond.

b. Should Kerr prefer the Colina over the Sentinal bond when rates are expected to rise or to fall?

c. What would be the effect, if any, of an increase in the volatility of interest rates on the prices of each bond?

a. The Sentinal bond will increase in value to 107.79 while The price of the Colina bond will increase, but only to the call price of 102

b. If rates are expected to fall, the Sentinal bond is more attractive while If rates are expected to rise, Colina is a better investment.

c. An increase in the volatility of rates increases the value of the firm’s option to call back the Colina bond.

See the step by step solution

Step by Step Solution

Evaluation of the effect of decline

a. The maturity of each bond is 10 years.

Let’s assume that coupons are paid semiannually.

Since both bonds are selling at par value, the current yield to maturity for each bond is equal to its coupon rate.

If the yield declines by 1%, to 5% (2.5% semiannual yield), the Sentinal bond will increase in value to 107.79 [n=20; i = 2.5%; FV = 100; PMT = 3]

The price of the Colina bond will increase, but only to the call price of 102. The present value of scheduled payments is greater than 102, but the call price puts a ceiling on the actual bond price.

Evaluation of preference between Colina and Sentinal bond

b. If rates are expected to fall, the Sentinal bond is more attractive: because

(i) it is not subject to being called,

(ii) its potential capital gains are higher.

On the other hand, If rates are expected to rise, Colina is a better investment because:

(i) Its higher coupon will provide a higher rate of return than the Sentinal bond.

Calculation of effect due to increase in volatility of interest rates

c. An increase in the volatility of rates increases the value of the firm’s option to call back the Colina bond. This makes the Colina bond less attractive to the investor.

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