Discussion 4

Discussion 4: Fixed income Valuation

Case Study: Fixed income Valuation (available in Course-Pack).

There are 6 questions in the case but please provide detailed answers to first 3 questions (Questions 1, 2 and 3) with two parts in each question.

In addition to responding to the case questions, please review the Problems provided below and include clear explanations for all questions presented in bold. If you provide correct answers to question 4 or 5 with good reasonings and logics, I will give you additional bonus points.

Problem 1: Part A of the first problem asks for the yield to maturity of a conventional fixed-rate bond issued at par with an annual coupon of 4.75%. The answer to this question, 4.75%. The follow-up questions about what the yield would have been had the bonds been priced at 99 or 101 instead of 100 illustrates the inverse relationship between price and yield for fixed-income securities. The core Idea of inverse relation is based on Opportunity Cost of Money. Please explain.

Problem 2: The second problem also asks students to estimate prices and yields on fixed-income securities, but introduces different frequencies in coupon payments, including annual, semi-annual, and zero-coupon payments. It is best to begin discussions of this problem by clarifying the difference between effective annual yield and bond-equivalent yield. The latter is simply twice the semi- annual yield and ignores compounding. This is the convention used in quoting yields for typical U.S. bonds making semi-annual coupon payments. The effective annual yield, in contrast, is the square of the semi-annual yield. This assumes that the semi-annual coupon received in the first half of the year is reinvested at the same semi-annual rate during the second half of the year. Why is the difference between effective annual yield and bond-equivalent yield. so important in corporate finance?

Problem 3: This problem is about amortizing debt instruments, mortgages in particular. Please explain how a conventional fixed-rate mortgage differs from the forms of debt analyzed in the previous problems.

Learning Objectives: These problem set are intended to introduce students to basic analytic techniques for determining the price and yield of various types of fixed-rate debt securities. The contexts in which the calculations are carried out invite some limited discussions of what determines bond yields, why yields on some bonds might differ from those on others, and how special features on certain instruments (e.g., tax-free industrial revenue bonds) might create savings for either the issuer or the investor. The problems are of low to moderate difficulty. They are best used in an introductory course in Finance, though even students with some background in finance will find these to be effective exercises for reviewing or consolidating their understanding of bond math. At Harvard Business School, these problems are used to begin a module on debt-security financing, and in a separate program designed to introduce students to a number of basic financial analytic techniques.