Question

1. Corporation Q issues 2 bonds with 20-year maturities. Both bonds are callable at $1,050. The first bond is issued at a deep discount with a coupon rate of 4% and a price of $580 to yield 8.4%. The second bond is issued at par value with a coupon rate of 8.75%

a. What is the YTM of the par bond? Why is it higher than the yield of the discount bond?

b. If you expect rates to fall substantially, in the next 2 years, which bond do you prefer to hold?

c. In what sense does the discount bond offer "implicit call protection"?

2. You are managing a portfolio of $1m. Your target duration is 10 years and you can choose from 2 bonds: a zero-coupon bond with maturity of 5 years, and a perpetuity, each currently yielding 5%.

a. How much of each bond will you hold in your portfolio?

b. How will these fractions change next year if target duration moves to 9 years?

3. Corporation X has issued bonds that pay annually with the following characteristics:

Coupon	YTM	Maturity	Macaulay Duration
8%	8%	15 years	10 years

a. Calculate modified duration using the information above

b. Explain why modified duration is a better measure than maturity when calculating the bond's sensitivity to changes in interest rates

c. Identify the direction of change in modified duration if:

i. The coupon of the bond were 4%, not 8%

ii. The maturity of the bond were 7 years, not 15

Answer 1

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