MGT201 GDB Solution IDEA 2012

Total Marks	2
Starting Date	Tuesday, November 27, 2012
Closing Date	Wednesday, November 28, 2012
Status	Open
Question/Description	Bond Valuation and Yield on Bond Learning Objective: To understand the application of bond valuation for investment decisions. Learning Outcome: After attempting this GDB, the students would be able to understand the application of bond valuation for investment decisions. The Case: Suppose, you are working as an investment consultant in a consultancy firm and most of your clients are habitual investors, who are maintaining their own portfolios comprising of various combinations of stocks and bonds.  Mr. Zahid, a habitual investor comes to you for consulting about adding one more potential investing option to his existing portfolio. Currently, as per your analysis, there are two bonds available in the market with the following data: Bond A Bond B Maturity 3 years 8 years Coupon payment 10% Annual 10% Semiannual Yield 6.23% 9.8% *Note: Interest rate fluctuations are high in the market Required: ·        Suggest Mr. Zahid, who is interested to add only one bond to his portfolio about the suitable bond for his portfolio. ·        Support your choice by elaborating the reason on which the suggested bond is considered as a preferred option. Important Instructions: 1.       Your discussion must be based on logical facts. 2.       The GDB will remain open for 2 working days/48 hours. 3.       Your answer should be relevant to the topic i.e. clear and concise. 4.       Your discussion should not exceed 60 words. 5.       Do not copy or exchange your answer with other students. Two identical / copied comments will be marked Zero (0) and may damage your grade in the course. 6.       Obnoxious or ignoble answer should be strictly avoided. 7.       Questions / queries related to the content of the GDB, which may be posted by the students on MDB or via e-mail, will not be replied till the due date of GDB is over. Ø        For detailed instructions, please see the GDB announcement.

SOLUTION IDEAS

Dear friends, if we consider the face value of both the bonds Rs. 1000. Then apparently it seems that investment in bond B will be better. Rest i can better comment after detailed calculations. Anybody who has different opinion can share immediately, so that we can arrive at correct solution by fruitful discussion

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I think, Bond A is better. Keeping in mind the following points:

Maturity: Shorter maturities have less risk, so their interest rates don't have to be as high as long-term maturities to attract buyers.
The longer the time to maturity for a bond, the greater the risk that the issuing company will experience financial trouble.

Coupon Payment: A bond with semiannual payments would have a higher price than a bond with annual payments when they both are selling at a premium. 

In general, bonds with semiannual payments are more sensitive to changes in market interest rates. For the same amount of decline in market interest rates, bonds with semiannual payments tend to see more price increases.
Hence the one with annual payments is better.
Read more: Bond Prices: Annual Vs. Semiannual Payments | eHow.com http://www.ehow.com/info_8552770_bond-annual-vs-semiannual-payments...

Yield: If you purchase a higher grade, lower yield bond, you are exposed to less default risk, and you have a higher chance of getting all of the promised coupon payments and the par value if you hold the bond to maturity.
Read more: http://www.investopedia.com/ask/answers/06/highyieldlowyieldbonds.a...

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if we go with the handout and lectures then Bond B is Better because long bond risk theory ,yield to maturity and biannual payment all says Bond B is better


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(i)

Face value= FV=Rs. 100

Annual Coupon = 10%

Yield = 6.23%

Maturity = 3 yrs

CF = Coupon Interest Rate * Par value

CF = 10% * 100

CF = Rs. 10 p.a

PV (6.23%) = CF /(1+6.23%)+ CF /(1+6.23%)²+ CF /(1+6.23%)³+ FV /(1+6.23%)³

PV = 10/1.0623 +10/(1.063) ² + 10/(1.063) ³+ 100/(1.063) ³

PV = 9.41 + 8.85 + 8.33 + 83.26

Bond Price = 109.85

Rs. 100 today at 10% mark-up for 3 years is worth positive Rs. 109.85 to the client today.

(ii)

Face value= FV=Rs. 100

Semi Annual Coupon = 10%

Yield = 9.8%, semi-annual = 4.9%

Maturity = 8 yrs

Total Coupon payments = 2*8 = 16 coupon payments

Each coupon payment = 10%*100

                                                = Rs. 10 p.6m

Bond Price = 10 * [1 – [ 1/(1+0.049)¹⁶]]/0.049 + 100/(1+0.049)¹⁶

Bond Price = 10 *[1-0.465]/0.049 + 100/2.15

Bind Price = 109 + 46.5

Bond Price = 155.5 = 156

Rs. 100 today at 10% mark-up semi-annual for 8 years is worth positive Rs. 156 to the client today.

When Market Interest Rate (ie. Investors’ Required Rate of Return) Increases, the Value (or

Price) of Bond Decreases. So, when interest rate in denominator goes up the present value (price) will decrease. When investor buy a long term bond he is locked in investment for long term period there are more chances of fluctuation in interest rate and the inflation rate.

So, the impact of interest rate changes on Long Term bonds is greater. Long Term Bond Prices fluctuate more because their Coupon Rates are fixed (or locked) for a long time even though Market Interest Rates are fluctuating daily; therefore the price of Long Bonds has to constantly keep adjusting. Price of the long term bond fluctuates more as compared to the short term bond.  So we will suggest Bond A to Mr. Zahid to add in his portfolio.

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