2. (a) (b) (c) Sarah has a 8-year investment horizon. She is considering purchasing a 12-year,...

 

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2. (a) (b) (c) Sarah has a 8-year investment horizon. She is considering purchasing a 12-year, 10% coupon bond. Coupon payments are made semi-annually and the bond has a face value of €1,000. The bond sells to offer a yield to maturity of 12% annually. Sarah expects to be able to reinvest the coupon payments at an annual interest rate of 8%. At the end of the planned investment horizon, the bond will be selling to offer a yield to maturity of 8% annually. (i) What proportion of the total future cash flow is accounted for by the interest-on-interest component? (ii) Calculate the total return carned by Sarah on a bond-equivalent basis. (iii) Calculate the total return carned by Sarah on an effective rate basis. Explain why the Total Return from holding a bond to maturity will be between the yield to maturity and the reinvestment rate. For a long-term high-yield coupon bond, will the total return from holding a bond to maturity be closer to the yield to maturity or the reinvestment rate? (You might want to use the example in (a) to illustrate your answers.) Assume that a company has issued a bond with an embedded call option. Explain the motivation behind that choice. Explain intuitively the impact of that decision on the bond price. (Hint: Take an identical bond with no embedded option and try to assess whether embedding a call option will decrease or decrease the bond price). 2. (a) (b) (c) Sarah has a 8-year investment horizon. She is considering purchasing a 12-year, 10% coupon bond. Coupon payments are made semi-annually and the bond has a face value of €1,000. The bond sells to offer a yield to maturity of 12% annually. Sarah expects to be able to reinvest the coupon payments at an annual interest rate of 8%. At the end of the planned investment horizon, the bond will be selling to offer a yield to maturity of 8% annually. (i) What proportion of the total future cash flow is accounted for by the interest-on-interest component? (ii) Calculate the total return carned by Sarah on a bond-equivalent basis. (iii) Calculate the total return carned by Sarah on an effective rate basis. Explain why the Total Return from holding a bond to maturity will be between the yield to maturity and the reinvestment rate. For a long-term high-yield coupon bond, will the total return from holding a bond to maturity be closer to the yield to maturity or the reinvestment rate? (You might want to use the example in (a) to illustrate your answers.) Assume that a company has issued a bond with an embedded call option. Explain the motivation behind that choice. Explain intuitively the impact of that decision on the bond price. (Hint: Take an identical bond with no embedded option and try to assess whether embedding a call option will decrease or decrease the bond price).

Answer rating: 100% (QA)

a i The interestoninterest component refers to the interest earned on reinvesting the coupon payments received from the bond The total future cash flow from the bond includes both the coupon payments ... View the full answer