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Value of outstanding bonds and rates of returns

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1 "The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices." Is this statement true or false? Explain.

2. The rate of return you would get if you bought a bond and held it to its maturity date is called the bond's yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond's price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond's price?

3. Two inventors are evaluating General Motors' stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the risk of the stock. However, one investor normally holds stock for 2 years, while the other normally holds stock for 10 years. Should they should both be willing to pay the same price for General Motors' stock. True or false? Explain.

4. A bond that pays interest forever and has no maturity date is a perpetual bond. In what respect is a perpetual bond similar to a no-growth common sock, and to a share of preferred stock?

5. Describe the effect on a call option's price caused by an increase in each of the following factors: (1) stock price, (2) strike price, (3) time to expiration, (4) risk-free rate, and (5) variance of stock return.

6. What is a financial option? What is the single most important characteristic of an option?

7. Consider Triple Trice's call option with a $25.00 strike price. The following table contains historical values for this option at different stock prices:

Stock price Call Option Price
$25 $3.00
$30 $7.50
$35 $12.00
$40 $16.50
$45 $21.00
$50 $25.00

(1) Create a table that shows (a) stock price, (b) strike price, (c) exercise value, (d) option price, and (e) the time value, which is the option's price less its exercise value.

(2) What happens to the time value as the stock price rises? Why?

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Solution Summary

The value of outstanding bonds and rates of returns are determined. Investors in general motors are examined.

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1. "The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices." Is this statement true or false? Explain.

Solution:-
The statement is false.
The longer the time to maturity, the higher is the sensitivity of the bond prices to changes in interest rates. The money invested in bonds is locked for longer duration while short term bonds mature and the proceeds can be reinvested to take advantage of interest rate changes.

2. The rate of return you would get if you bought a bond and held it to its maturity date is called the bond's yield to maturity. If interest rates in the economy rise after a bond has been issued, what will happen to the bond's price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond's price?

Solution:-

If interest rate increase, the price of the bond will decline and YTM on the bond will increase for the new investors (the existing investors will still receive the old YTM if the bonds are held till maturity).

The YTM on bonds will reflect the long term interest rate prevailing in the market. The YTM of the bodn is composed of two components - coupon interest rate and capital appreciation. As YTM has gone up with increase in interest rates, while the coupon rate remained constant, the additional YTM will be provided by the capital appreciation decline in bond price to the new investor.

3. Two inventors are evaluating General Motors' stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, ...

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