Question 1
Proficient-level: “What is the purpose of a call provision or call feature for bond issuers?” (Cornett, Adair, & Nofsinger, 2016, p. 184).
Distinguished-level: Explain the additional compensation paid when a bond is called.
Call provisions allow bond issuers to recall bonds before the scheduled maturity date. This is advantageous for issuers as they can refinance their debt at lower interest rates. When a bond is called, the issuer pays the bondholders the principal amount and a call premium, compensating for the lost future interest payments. This incentivizes bondholders to agree to the call provision.
Question 2
Proficient-level: “Define a discount bond and a premium bond, and provide examples.” (Cornett, Adair, & Nofsinger, 2016, p. 184).
Distinguished-level: Explain how bond prices reflect changes in market interest rates.
Discount bonds are sold below par value, while premium bonds are sold above par value. Market interest rate changes affect bond prices. When market rates are lower than a bond’s coupon rate, it becomes a premium bond as investors chase higher yields. Conversely, when market rates surpass the coupon rate, it becomes a discount bond due to reduced demand and lower prices. BUS 3062 Unit 3 Assignment 1 Valuing Bonds
Question 3
Proficient-level: “Describe the differences in interest payments and bond prices between a 5 percent coupon bond and a zero coupon bond.” (Cornett, Adair, & Nofsinger, 2016, p. 184).
Distinguished-level: Determine which of the two bonds would remain closer to its par value given a change in market interest rates.
A 5 percent coupon bond pays an annual interest of 5 percent of its par value, such as $50 for a $1,000 bond. This interest is typically paid semi-annually at $25. The price of a coupon bond stays close to its par value because investors receive regular interest payments.
In contrast, a zero coupon bond doesn’t make regular interest payments. Instead, the bondholder earns a return from the bond’s market price increase over time. Zero coupon bonds are initially sold at a significantly lower price than their par value. For example, a $1,000 zero coupon bond might be sold for $700, resulting in a $300 return at maturity. Zero coupon bonds differ from coupon bonds by not providing interest payments.
BUS 3062 Unit 3 Assignment 1 Valuing Bonds
If market interest rates change, the coupon bond is more likely to stay closer to its par value than the zero coupon bond. Regular interest payments stabilize the coupon bond’s price. On the other hand, zero coupon bonds rely on market price appreciation for their return, making them more sensitive to interest rate changes. This sensitivity can lead to greater price volatility for zero-coupon bonds.
Question 4
Proficient-level: “Calculate the price of a zero coupon bond that matures in 20 years with a market interest rate of 3.8 percent.” (Cornett, Adair, & Nofsinger, 2016, p. 185).
Assume semi-annual compounding.
Distinguished-level: Explain why zero coupon bonds are sold at steep discounts.
The zero coupon bond’s price (present value) will be between $470.00 and $479.99. (Please note the known variables required to obtain the correct response.) This calculation assumes semi-annual compounding.
Zero coupon bonds are sold at significant discounts from their face value, the amount returned at maturity. Unlike coupon bonds that provide regular interest payments, zero coupon bonds do not offer any interest income during their term. Instead, investors earn a return through the price appreciation from the initial purchase price to the face value at maturity.
Zero coupon bonds are priced below their face value to account for the lack of interest payments. The discount represents the forgone interest earnings. A more considerable discount translates to a higher potential yield for investors, making zero-coupon bonds attractive for long-term investment and capital appreciation.
Question 5
Proficient-level: “Compute the price of a 3.8 percent coupon bond with 18 years left to maturity and a market interest rate of 6.8 percent.” (Cornett, Adair, & Nofsinger, 2016).
Assume semi-annual interest payments and solve using semi-annual compounding.
Distinguished-level: Explain whether the bond is a discount or premium bond.
The coupon bond price falls between $690.00 and $699.99 (with known variables considered). If the bond trades below its face value, it is a discount bond. If the bond trades above its face value, it is a premium bond.
Since the coupon bond price falls below $1,000.00, it is a discount bond.
Question 6
Proficient-level: “A 5.65 percent coupon bond with 18 years left to maturity
It is offered for sale at $1,035.25. What yield to maturity (interest rate) is the bond offering?” (Cornett, Adair, & Nofsinger, 2016, p. 186).
Assume semi-annual interest payments and solve using semi-annual compounding.
Distinguished-level: Explain the effect of a decrease in the offered sales price on the yield to maturity.
The bond’s yield to maturity (interest rate) will be between 5.00% and 5.99%. Make sure to solve and provide the response with four decimal places. (Please note the known variables required to obtain the correct answer.) This calculation assumes semi-annual compounding.
BUS 3062 Unit 3 Assignment 1 Valuing Bonds
A lower sales price for a bond leads to a higher yield to maturity. The work to maturity indicates the expected total return for an investor who holds the bond until maturity. When the sales price decreases, the potential return increases as the investor pays less for the same future cash flows. This increased return is reflected in the higher yield-to-maturity calculation. In summary, a lower sales price corresponds to a higher yield to maturity for the bond.
References
Cornett, M. M., Adair, T. A., & Nofsinger J. (2016). M: Finance (3rd ed.). New York, NY: McGraw-Hill.
