Really worth 9 points) A bondholder purchased a 7.5% coupon, $1,000 par three-ye

Question

Really worth 9 points) A bondholder purchased a 7.5% coupon, $1,000 par three-year bond at a 7.5% yield. Interest rates then immediately fell to 5.5% and her bond was called at a price of $1,035. She reinvested her money and earned 5.5% on the $1,035 for three years. What was her three-year rate of return on the original investment to 2 decimal places? What was the basis point increase or decrease in return resulting from the call? What was the dollar increase or decrease in return resulting from the call to the nearest penny? uestion 27

Explanation / Answer

Solution:

Present Value (PV) = $1,035

k = 5.5% = 0.055

n = 3 years

PV = FV (1 + k)n

$1,035 = FV (1 + 0.055)3      

Fair Value (FV) = $1,215.34

Now,

PV = $1,000

n = 3 years

FV = $1,215.34 (as calculated above)

PV = FV (1 + k)n

$1,000 = $1,215.34 (1 + k)3

k = 6.72%

The three-year rate of return on original investment was 6.72%

The basis point decrease in return resulting from the call was 0.78% less than the original (7.5% - 6.72%)

The dollar increase in return resulting from the call was $180.34 ($1,215.34 - $1,035)

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