Part I: Bonds
To review the configuration of today's "yield curve" click on the following: http://www.bondsonline.com/Todays_Market/Treasury_Yield_Curve.php
A simple calculator of the yield to maturity of a bond
can be found at the following site.
As an alternative you may use Excel spreadsheet in order to perform the computations. Here's an example showing how to do this.
1. Consider the following information on a series of government bonds
as of this week. All bonds
have a "face value' or maturity value of $1,000:
No. Maturity Coupon Price Yield to Maturity
1 2 years $51 $993 ?
2 3 years $46 ? 5.54%
3 4 years $61 $1,017 ?
4 6 years $54 ? 5.84%
5 6 years $9 ? 5.80%
(a) Compute the yield to maturity on bonds
no. 1 and 3, and the market price of bonds
no. 2, 4 and 5 (the market price is actually the present value of the cash flow that a buyer of the bond
receives, where the present value is computed using the yield to maturity that is given).
(b) Plot on a diagram the yield to maturity of the bonds
as a function of the time to maturity. You may find how such a Yield Curve looks like today by referring to the web site cited on the top of this page. What you should do is to prepare a diagram where you plot five 'dots' - one for each of the bonds
. On the horizontal axis you depict the number of years until maturity of each bond
and on the vertical axis the yield to maturity of the same bond
. Then connect the dots 'free hand' - that is, pass a curve through these bonds
. The graph is known as 'The Yield Curve' for a particular date. You may use the Excel graphics. Choose THE XY (scatter) PLOT in Excel, not the line plot because otherwise bonds
4 and 5 will be plotted as if they mature in 5 and in 6 years while both mature in 6 years. You may again refer to the example by clicking here.
(c) What might explain this 'shape' of the yield curve? Refer to the literature (Pool's article in the Background readings) or by browsing on the Internet to find the term 'Yield curve'. You are required to provide references to your sources.
(d) Now assume that the Federal Reserve System lowered interest rates and that as a results the yield to maturity on all of these bonds
fell by one half of a percentage point. (This means from 5.54% to 5.04%, and from 5.84% to 5.34% etc.). Compute the new market prices of all of the bonds
. Once you did this, compute and examine the percentage change of the price of each of these bonds
from its original price. Which bond
price moved by the largest percentage? Which bond
price moved by the smallest percentage?
(e) Go back to the original set of bond
prices and yields and now assume that the yield to maturity on all of the bonds
rose by 0.5 percent. Compute the new prices of all five bonds
and then the percentage change in the price of the bond
from its original price. Which bond
price fell by the largest percentage? The smallest?
(f) What conclusions can you draw from the results in (d) and in (e) with regard to the risk of investing in bonds
if investors with to hold their investment only for a short time? Be sure to explain.
(g) The bonds
that you analyzed above were default-free government bonds
. You must have realized that even these bonds
are risky in the sense that investors in these bonds
for a short time are not certain about the rate of return that they'll earn on their investment. Now explain the implications of the results to companies that wish to raise funds by issuing bonds
. Note that corporate bonds
are not default-free...
Part II: Stocks
The dividend growth model referred to in the background readings provides some 'clues' to what might determine and affect stock prices. Briefly describe the three components that affect stock prices according to the model and discuss the practical difficulties you see in applying the model in order to determine the 'proper' price of a stock.
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