Grandpa Russ thinks he needs a fixed income for the next 10 years. He currently
ID: 2769486 • Letter: G
Question
Grandpa Russ thinks he needs a fixed income for the next 10 years. He currently has $10,000 in CDs, which are maturing at the end of this month. The CDs can be renewed for one year at 4.5 percent. Russ calls his broker, Ben Seller, and learns that this $10,000 can be put to better use by purchasing debentures issued by Grab-n-Run, Inc. These bonds are 10-year bonds with a coupon rate of 8 percent, which is paid semiannually. The current market interest rate is 6 percent for bonds of similar nature. The broker tells Grandpa Russ that he may buy each bond for $1,400. Grandpa knows that he must pay a premium, but he believes that a $400 premium is too high.
A. What is the maximum price you should tell Grandpa to pay for each bond?
B. Compare the risk of the CD with the risk of the bond.
C. What else would you advise Grandpa with regard to this type of investment?
Explanation / Answer
Price of the bond can be calculated using financial calculator as below
FV= $1000, N=10*2, Coupon= 8%/2*1000=$40
Let us assume that YTM= 6%/2( Semi annual yield, 6% is what similar bonds are paying so assumed YTM= 6%)
Compute PV
PV= $1148.77
Thus, the maximum price you should tell Grandpa to pay for each bond is $1148.77
B.
Compare the risk of the CD with the risk of the bond.
Risk of CD- Interest rate risk is the major risk. If interest rates go up one can not benefit from it. CDs are considered low risk investment. They are generally issued by banks so they are insured by FDIC. They pay low interest rate due to low risk so they may not beat inflation. Principal is safe in CDs.
Risk of bond- Bond also has interest rate risk. Other type of risks are company specific. If comapny goes bankrupt bond holders will not get money. Thus their is siginficant default risk with bonds. That is why bond pays higher interest than CDs.
What else would you advise Grandpa with regard to this type of investment?
Grandpa may invest part of investment in CDs and some part in less risky bonds which will give slightly higher returns and principal will also be saved.
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