Part I:
Bond No. Maturity Coupon Price Yield to Maturity
1 2 years $50 $992 ?
2 3 years $45 ? 5.52%
3 4 years $60 $1,015 ?
4 6 years $54 ? 5.82%
(a) Compute the yield to maturity on bonds no. 1 and 3, and the market price of bonds no. 2 and 4 (the market price is actually the present value of the cash flow that a buyer of the bond receives, where the present value is computed using the yield to maturity that is given).
(b) Plot on a diagram the yield to maturity of the bonds as a function of the time to maturity. That means use a diagram where you show the number of years until maturity of each bond and on the vertical axis the yield to maturity. The graph is known as 'the yield curve'. What might explain this 'shape' of the yield curve? Refer to the literature by browsing on the Internet to find the term 'Yield curve' and provide references to your sources.
(c) Now assume that the Federal Reserve Banks lowered interest rates and that as a results the yield to maturity on all of these bonds fell by one half of a percentage point. (This means from 5.54% to 5.04%, and from 5.80% to 5.30% etc.). Compute the new market prices of all of the bonds. Once you did, examine the percentage change of the price of each of these bonds. Which bond price moved by the highest percentage? Which bond price moved by the lowest percentage?
(d) Go back to the original set of bond prices and yield and now assume that the yield to maturity on all of the bonds rose by 0.5 percent. Compute the new prices of all four bonds. Which bond price fell by the highest percentage? The lowest?
(e) What conclusions can you draw from the results in (c) and in (d) with regard to the risk of investing in bonds if investors with to hold their investment only for a short time? Be sure to explain.
(f) Explain the implications of the results to companies that wish to raise funds by issuing bonds.
Part II: Stocks
a) Briefly describe the three components that affect stock prices and discuss the practical difficulties you see in applying them in order to determine the 'proper' price of a stock.