Peter is analyzing the following three bonds for investment BondA- A15-year,$1,0

Question

Peter is analyzing the following three bonds for investment BondA- A15-year,$1,000,5%semi-annual couponbondiss ued by Company A Bond B A10-year, $1,000, 6% semi-annual couponbondissuedbyCompanyB Bond-A15-year, $1,000, zerocoupon bondissuedbyCompanyC- (a) If Bond C (a zero coupon bond) is currently trading at $670, what is YTM of Bond C? (b) (c) Assume annual compounding (2 marks) If Bond A is currently trading at par, what is the market price of Bond B if it has the same YTM as Bond A? (3 marks) i) What is the current yield of Bond A? ii) (2 marks) Suppose Bond A's YTM drops by 1% one year later, what is the capital gains yield (4 marks) of Bond A at that time? If Peter expects the interest rate to drop in the coming year, which bond (Bond A, Bond B or Bond C) would Peter choose to buy today? Explain briefly. (d) (2 marks)

Explanation / Answer

YTM of bond C=(1000/670)^(1/15)-1=2.7058%

If Bond A is trading at par, the ytm must be equal to coupon rate=5%
Price of Bond B=30/1.025+30/1.025^2..........30/1.025^20+1000/1.025^20=476.7427

Current Yield of Bond A=25*2/1000=5%

Next year price will be=25/1.02+25/1.02^2..........25/1.02^18+1000/1.02^18=1074.96

Highest duration is for Bond C given duration is directly proportional to maturity and inversely proportional to coupon rate..

Hence, if interest rates drop, the highest price increase will be for BondC..So buy Bond C

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