Question

chapter 3

QUESTIONS 1. Write down the formula that is used to calculate the yield to maturity on a 20-year 10% coupon bond with $1,000 face value that sells for $2,000. 2. If there is a decline in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk? 3. A financial adviser has just given you the following advice: "Long-term bonds are a great investment because their interest rate is over 20%." Is the finan- cial adviser necessarily right? 4. If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more or less likely to buy houses?

Answer 1

Answers:

1). $2,000 = $100/(1 + i) + $100/(1 + i)² + .......+ $100/(1 + i)²⁰ + $1,000/(1 + i)²⁰

Solving i will give 'yield to maturity'.

2). I would rather be holding the long term bonds as price of long term bonds will increase higher than short term bonds price, which gives higher return. Long term bonds are more likely to higher price fluctuations than the short term bonds. So they have higher risk on interest rates.

3). No. If the interest rates rise quickly in the coming future, long-term bonds may face such a quick down fall in the price too. So their return might be low, probably even comes to negative.

4). The people are more likely to buy houses. Reason is that the actual interest rate while purchasing a house has went down from 3% (that is 5% - 2% = 3%) to 1% (that is 10% - 9% = 1%).

Though the mortgage rates have gone up, the actual cost of financing the house is lower. Also people will more likely purchase houses, if the interest payment of mortgage is considered for tax deductibility.