Solutions to Case Problems
Case 11.1 The Bond Investment Decisions of Dave and Marlene Carter
In this case, the student is asked to evaluate two bond trading opportunities—one involves using bonds to
speculate on short-term interest rate movements, and the other deals with a bond swap.
a. 1. The Carters are attempting to speculate on interest rates by seeking capital gains from an
expected drop in rates.
2. The price of the bond in 2 years (when it has 23 years to maturity):
Price of bond
3. Using the formula for expected return:
4. Although this appears to be an attractive investment, one must compare the expected return with
other possible alternatives. Presuming the expected rate of return (of 14%) is commensurate with
b. 1. We will evaluate the current and promised yields using the text’s formulas.
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204 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
Current Yield Annual Interest/Current Price
Beta Corporation:
YTM computation
Dental Floss, Inc:
Root Canal Products:
2. Dental Floss offers higher current but slightly lower promised yield than Beta Corporation.
3. Depending on whether The Carters are investing for current income or long term return, they
Case 11.2 Grace Decides to Immunize Her Portfolio
a. Current and promised yield calculations:
Current yield
YTM computation
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Chapter 11 Bond Valuation 205
Using a financial calculator as shown above, the promised return is 8.96%.
Bond 2: 10 years, zero coupon; currently priced at $405
Bond 3: 10 years, 10% coupon; currently priced at $1,080
Current yield
Using a financial calculator and the procedure shown for Bond 1, the expected return is 8.77%.
Bond 4: 15 years, 9.25% coupon; currently priced at $980
Current yield $92.50/$980 = 9.44%
Using a financial calculator and the procedure shown for Bond 1, the expected return is9.51%.
b. Duration and price volatility
Bond 1: 12 years, 7.5% coupon; currently priced at $895 to yield 8.96%
Percent change in bond price 1 Modified duration Change in interest rate
Bond 2: 10 years, zero coupon; currently priced at $405 to yield 9.46%
The price of the bond will fall by 6.83% if interest rate rises 0.75% and vice versa.
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$100 9.26%
$1,080 =
206 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition
Bond 3: 10 years, 10% coupon; currently priced at $1,080 to yield 8.77%
Bond 4: 15 years, 9.25% coupon; currently priced at $980 to yield 9.51%
The price of the bond will fall by 5.90% if interest rate rises 0.75% and vice versa.
c. When Grace invests $50,000 in each of the four bonds, the weighted average duration of the bond
portfolio would be:
(1) (2)
Bond
Particulars
(3)
Amount
Invested
(4)
Weight
(5)
Bond
Duration
(6)
Weighted
Duration
(4) (5)
The duration of the portfolio is 8.4years. Grace’s investment horizon is 7 years; therefore, the bond
portfolio is not immunized because the weighted average of the portfolio is greater than the
investment horizon.
d. The bond with the highest duration is the zero-coupon bond (10 years). The bond with the lowest
duration is the 10%, 10-year bond. To lengthen the portfolio’s duration, Grace could invest in higher
e. Grace is planning to cash out of the bond portfolio in about 7 years and wants to immunize the
portfolio. To do so, we must find a portfolio with a weighted average duration of 7 years. The easiest
way to immunize her portfolio from interest rate risk is to invest all of the $200,000 in the 10-year,
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Chapter 11 Bond Valuation 207
f. See the end of the answer to part e for an example of an immunized portfolio. Regardless of how
Answers to CFA Questions (Part IV)
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