Question

Question 2: Your company has purchased (invested) 2 (one of each A and B) annual-coupon paying bonds. Bond A is a 2-year, 6% coupon with a $1,000 face value and bond B is a 3-year, 16% coupon with a $1,000 face value. The YTM for both these bonds is 8%. Which of the following statements is true?

A) Bond A is a premium bond and Bond B is a discount bond.

B) The duration of portfolio investment in A and B is equal to 2.33 years.

C) Bond A has lower default risk, but higher interest rate risk than bond B.

D) The duration of portfolio investment in A and B is equal to 2.29 years.

E) Selling a single bond with a face value of $1,000, a YTM of 8%, and a duration equal to that of the portfolio investment, creates a dollar-for-dollar hedge of the company’s investment in A and B.

Question 3: The current stock price (year 0) of the Sizzling Sausage Corporation (SSC) is $40.50. According to your information and analysis, you expect this company to pay its first dividend of $2.50 in year 2, and from year 3 on, you expect to see growth in dividends. Specifically, you figure out that the dividends in year 3 will be $2.75 and will then continue to grow for another 15 years at 3.5% per year, after which it will grow 2.5% per year forever. The appropriate discount rate is 9%. If you currently own this stock and may ignore transaction costs, which of the following statements is true?

A) Sell your stock in SSC because the discount rate is much higher than the growth rate in dividends.

B) Purchase more stock in SSC because dividends are expected to continue to increase and grow indefinitely.

C) Sell your stock in SSC because based on your expectations the value of the stock is only $40.23

D) Purchase more stock in SSC because based on your expectations, the value of the stock is $98.46

E) Purchase more stock in SSC because based on your expectations the value of the stock is $41.21

Answer 1

A) Price of Bond A

= 60/0.08*(1-1/1.08^2)+1000/1.08^2

= $964.33

Price of Bond B

=160/0.08*(1-1/1.08^3)+1000/1.08^3

=$1206.17

So, the Bond A is trading at discount and Bond B is trading at premium. So, the Statement A is FALSE

Duration of Bond A = (60/1.08*1+1060/1.08^2*2)/964.33 =1.9424 years

Duration of Bond B = (160/1.08*1+160/1.08^2*2+1160/1.08^3*3)/1206.17 =2.6406 years

Duration of portfolio = 964.33/(964.33+1206.17)*1.9424 + 1206.17/(964.33+1206.17)*2.6406 = 2.33 years

Statement B is TRUE

Data is not sufficient to compare the default risk of the bonds . So statement C is FALSE

Statement D is obviously FALSE as the Duration of portfolio is 2.33 years

To Create a Dollar for Dollar Hedge, Bond worth $2000 has to be sold. Statement E is FALSE