FI Valuation

Stellar Corp. recently issued $100 par value deferred coupon bonds, which will make no coupon payments in the next four years. Regular annual coupon payments at a rate of 8% will then be made until the bonds mature at the end of 10 years. If the bonds are currently priced at $87.00, their yield to maturity is closest to:

  1. 6.0%.
  2. 8.0%.
  3. 10.1%

the answer is A

plz, help HOW?

Hello there,

You’ve got a 10 year bond here that doesn’t pay a coupon in the next four years. First coupon is at time 5, so you’re looking to get the PV of 6 payments (5,6,7,8,9,10) of $8 and a future value of $100. If you use the 6% YTM you’ll get a value of $109.83.

But that’s at the start of the first coupon payment period (time 4), so you still need to discount it back to today to get the price. Discount it 4 years at 6% and boom.

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If you’re given this sort of problem on the exam, try Richie’s scheme with the middle number (here: 8.0%). if that gives you a price of 87, you’re done: 8.0% is the correct yield. If it gives you a price higher than 87, then 8.0% is too low: the answer is 10.1%. If it gives you a price lower than 87, then 8.0% is too high: the answer is 6.0%

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On the BAII

CF worksheet
2nd CLR WRK
CF0 = -87 C01=0 F01=4 C02=8 F02=5 C03=108 F03=1
2nd Quit
IRR CPT 5.999909629

:nerd_face:

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Qs like this are mostly intuitive and require no calculation ( of course given the choices).

Why would you invest in a bond that does not give anything for the first 4 and you hold onto it with the promise of 8% after that for the next 6 ?

Only when you don’t have better investment alternatives which puts option B and C out of contention ( the issuer will not have any taker if the 10% and 8% were avl). Hence the market interest rate must be less than 8% for the math to work. Option A becomes the choice.

But you may also be presented with all 3 options less than 8%. Then what ?

Breadmakers CF method is surest. Else you can use Magician’s trial method in TVM.

If I were there, I would observe and weigh the options first before putting my Calculator to work

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