Judy Johnson is choosing between investing in two Treasury securities that matur

Question

Judy Johnson is choosing between investing in two Treasury securities that mature in five years and have par values of $1,000. One is a Treasury note paying an annual coupon of 5.06 percent. The other is a TIPS which pays 3 percent interest annually

                   A. What is the price if investors' required rate of return is 6.09 percent on similar notes? Treasury notes pay interst semi annually.

                   B. Erron Corporation wnts to issue five year notes but investors require a credit risk spread of 3 percentage points. What is the anticipated coupon rate on the Erron notes?

Explanation / Answer

Tips are securities that pay inflation adjusted interest. So in this case the interest would be the stated interest plus the inflation rate so, 2+3=5%. On the other hand, the treasury bills are not adjusted for inflation and the effective interest will decrease, because as you may know with inflation the value of money goes down. Assuming you don't know what the idea of inflation is, I will explain, imagine you have a bottle of water in the desert, that bottle of water must be worth a lot of money since it is so scarce, but in the u.s. it is worth two bucks. Same idea goes for a dollar's worth. If the government prints a lot of new dollars the existing dollars will be worth less because there are more of them, just like with water in the u.s. there is a lot of it so it isn't as pricey as the desert water.

Obviously you will earn more effective interest with the tips, since inflation is covered.

With that in mind, the effective interest, what we are effectively earning on the tips with the inflation, is 5.06% - 2% = 3.06%.

Principle value rises to $1000 plus 2% or $1,020. The effective interest 5.06% - 2% = 3.06%. Annual interest income from the TIPS bond = 1000 x 0.02 x 5 = $100
TIPS bond
First year: value: 1020 interest 30.6
Second year: value: 1040.4 interest: 31.21
Third year: value: 1061.21 interest: 31.84
Fourth year value: 1082.43 interest: 32.47
Fifth year value: 1104.08 interest: 33.12

Treasury note
First year: value: 1020 interest 51.61
Second year: value: 1040.4 interest: 52.64
Third year: value: 1061.21 interest: 53.70
Fourth year value: 1082.43 interest: 54.77
Fifth year value: 1104.08 interest: 55.87

(a)    How much interest will Judy receive over the five years from the Treasury note? From the TIPS?

Interest from Treasury note: 268.59
Interest The TIPS: 159.24

(b)   When each bond matures, what par value will Judy receive from the Treasury note? The TIPS?

$.03 % x $1,000 = $30.00

(c)    After five years, what is Judy%u2019s total income (interest + par) from each bond? Should she use this total as a way of deciding which bond to purchase?

P4.

Assume a $1000 face value bond has a coupon rate of 8.5 percent, pays interest semi-annually, and has an eight-year life. If investors are willing to accept a 10.25 percent rate of return on bonds of similar quality, what is the present value or worth of this bond?

Rb = (1 + market price)1/2 - 1

Rb = (1 + 0.1025)1/2 %u2013 1

Rb = (1.1025)0.5 %u2013 1

Rb = 1.05 %u2013 1

Rb = 0.05

Rb = 5%

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