Dave and Marlene Carter live in the Boston area, where Dave has a successful orthodontics practice. Dave

Question:

Dave and Marlene Carter live in the Boston area, where Dave has a successful orthodontics practice. Dave and Marlene have built up a sizable investment portfolio and have always had a major portion of their investments in fixed-income securities. They adhere to a fairly aggressive investment posture and actively go after both attractive current income and substantial capital gains.

Assume that it is now 2013 and Marlene is currently evaluating 2 investment decisions: one involves an addition to their portfolio, the other a revision to it.

The Carters’ first investment decision involves a short-term trading opportunity. In particular, Marlene has a chance to buy a 7.5%, 25-year bond that is currently priced at $852 to yield 9%; she feels that in 2 years the promised yield of the issue should drop to 8%.

The second is a bond swap. The Carters hold some Beta Corporation 7%, 2026 bonds that

are currently priced at $785. They want to improve both current income and yield to maturity and are considering 1 of 3 issues as a possible swap candidate:

(a) Dental Floss, Inc., 7.5%, 2038, currently priced at $780;

(b) Root Canal Products of America, 6.5%, 2026, selling at $885; and

(c) Kansas City Dental Insurance, 8%, 2027, priced at $950. All of the swap candidates are of comparable quality and have comparable issue characteristics.

Questions

a. Regarding the short-term trading opportunity:

1. What basic trading principle is involved in this situation?

2. If Marlene’s expectations are correct, what will the price of this bond be in 2 years?

3. What is the expected return on this investment?

4. Should this investment be made? Why?

b. Regarding the bond swap opportunity:

1. Compute the current yield and the promised yield (use semiannual compounding) for the bond the Carters currently hold and for each of the 3 swap candidates.

2. Do any of the swap candidates provide better current income and/or current yield than the Beta Corporation bonds the Carters now hold? If so, which one(s)?

3. Do you see any reason why Marlene should switch from her present bond holding into one of the other issues? If so, which swap candidate would be the best choice? Why?

Corporation
A Corporation is a legal form of business that is separate from its owner. In other words, a corporation is a business or organization formed by a group of people, and its right and liabilities separate from those of the individuals involved. It may... Expected Return
The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these... Maturity
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist. The term is commonly used for deposits, foreign exchange spot, and forward transactions, interest... Portfolio
A portfolio is a grouping of financial assets such as stocks, bonds, commodities, currencies and cash equivalents, as well as their fund counterparts, including mutual, exchange-traded and closed funds. A portfolio can also consist of non-publicly...