Chapter 3: Q-10-391 (page 332)
Question: Under the liquidity preference theory, if inflation is expected to be falling over the next few years, long-term interest rates will be higher than short-term rates. True/false/ uncertain? Why?
Answer
Uncertain
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Long-term Treasury bonds currently sell at yields to maturity of nearly 8%. You expect interest rates to fall. The rest of the market thinks that they will remain unchanged over the coming year.
Choose the bond that will provide the higher capital gain in each question if you are correct. Briefly explain your answer.
a. (1) A Baa-rated bond with a coupon rate of 8% and a time to maturity of 20 years.
(2) An Aaa-rated bond with a coupon rate of 8% and a time to maturity of 20 years.
b. (1) An A-rated bond with a coupon rate of 4% and maturity of 20 years, callable at
105.
(2) An A-rated bond with a coupon rate of 8% and maturity of 20 years, callable at
105.
c. (1) A 6% coupon noncallable T-bond with a maturity of 20 years and YTM 5 8%.
(2) A 9% coupon noncallable T-bond with a maturity of 20 years and YTM 5 8%.
Question: A large corporation issued both fixed- and floating-rate notes five years ago, with terms given in the following table:
9% Coupon Notes | Floating Rate note | |
Issue size | 250 million | 280 Million |
Maturity | 20 Years | 15 Years |
Current Price (% of par | 93 | 98 |
Current Coupon | 9% | 8% |
Coupon Adjusts | Fixed coupon | Every year |
Coupon reset rule | ----- | 1 Year T bill rate + 2% |
Callable | 10 Years after issue | 10 Years after issue |
Call Price | 106 | 102 |
Sinking fund | None | None |
Yield to Maturity | 9.9% | --------- |
Price range since issued | \(85 - \)112 | \(97 - \)102 |
a. Why is the price range greater for the 9% coupon bond than the floating-rate note?
b. What factors could explain why the floating-rate note is not always sold at par value?
c. Why is the call price for the floating-rate note not of great importance to investors?
d. Is the probability of call for the fixed-rate note high or low?
e. If the firm were to issue a fixed-rate note with a 15-year maturity, callable after five years at 106, what coupon rate would it need to offer to issue the bond at par value?
f. Why is an entry for yield to maturity for the floating-rate note not appropriate?
Find the duration of a 6% coupon bond making annual coupon payments if it has three years until maturity and a yield to maturity of 6%. What is the duration if the yield to maturity is 10%?
Spice asks Meyers (see the previous problem below) to quantify price changes from changes in interest rates. To illustrate, Meyers computes the value change for the fixed-rate note in the table. He assumes an increase in the interest rate level of 100 basis points. Using the information in the table, what is the predicted change in the price of the fixed-rate note?
Frank Meyers, CFA, is a fixed-income portfolio manager for a large pension fund. A member of the Investment Committee, Fred Spice, is very interested in learning about the management of fixed-income portfolios. Spice has approached Meyers with several questions. Specifically, Spice would like to know how fixed-income managers position portfolios to capitalize on their expectations of future interest rates.
Meyers decides to illustrate fixed-income trading strategies to Spice using a fixed rate bond and note. Both bonds have semi-annual coupon periods. All interest rate (yield curve) changes are parallel unless otherwise stated. The characteristics of these securities are shown in the following table. He also considers a nine-year floating-rate bond (floater) that pays a floating rate semi-annually and is currently yielding 5%.
Spice asks Meyers about how a fixed-income manager would position his portfolio to capitalize on expectations of increasing interest rates. Which of the following would be the most appropriate strategy?
a. Shorten his portfolio duration.
b. Buy fixed-rate bonds.
c. Lengthen his portfolio duration.
Which security has a higher effective annual interest rate?
a. A three-month T-bill with face value of \(100,000 currently selling at \)97,645.
b. A coupon bond selling at par and paying a 10% coupon semi-annually.
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