Question: Sam Strother and Shawna Tibbs are vice presidents of Mutual of Seattle Insurance Company and co-directors of the company's pension fund management division. An important new client, the North-Western Municipal Alliance, has requested that Mutual of Seattle present an investment seminar to the mayors of the represented cities, and Strother and Tibbs, who will make the actual presentation, have asked you to help them by answering the following questions.
a. (1) what is the yield to maturity on a 10-year, 9% 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 rd 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.)
b. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10% coupon bond if the nominal rd = 13%.
c. Suppose a 10-year, 10% 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%. However, the bond can be called after 5 years for a price of $1,050.
(1) What is the bond's nominal yield to call (YTC)?
(2) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why?
d. 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?
e. What is reinvestment rate risk? Which has more reinvestment rate risk: a 1-year bond or a 10-year bond?
f. What is the term structure of interest rates? What is a yield curve?