Introduction
The purpose of this exercise is to explain how the market prices of debt instruments (bonds) are different and why they may change.
Assume that you are an intern in the West Wing of the White House. Your boss comes to your cubical and shows you a letter that was sent to the President. He asks you if can handle the matter. Here is the letter:
“Dear Mr. President,
Five years ago my son gave me a nice 50th birthday gift. He purchased for me a US government bond that pays $80 a year for thirty years. After 30 years I will receive the principle of $1,000.
Last week, I decided to sell the bond and to use the $1,000 proceeds to pay for my dream trip to Ireland. I booked the trip and then sold the bond. Well, I received only $900 for the bond.
Dear Mr. President, I am upset for at least three reasons:
I thought the bond would pay for the entire trip. Now, I am not sure I can go.
I thought my son gave me a $1,000 gift, but the gift is worth only $900.
I always thought that US government IOUs are risk proof. I can’t understand how a US government IOU loses value.
HELP!!!!!!!
A very Unhappy Citizen
Instructions
Since you are a recent college graduate with a major in finance you decide that this is the time for you to make your mark. You open your Finance textbook (which you always kept for future reference) and immediately find the following quote: “The value of bonds can change substantially over time” (Madura)
Prepare a reply to the unhappy citizen. Use the following website and/or Wall Street Journal hard copy in order to explain the issue.
Do the following:
1. Based on the following source, show that fluctuations in bond prices are universal. It is not just the case of US government bonds.
Go to www.yahoo.com . Click on Finance then Market Data then Bonds then Bond Screener. Check Treasury and then Find Bonds. Press Next several times.
Remember that bond price quotations are expressed as a percent of par value. Thus, a quotation of 101 means the price is 101% of par, or $1010 for a $1000 face value bond (realize, some of these bonds are quoted at over 130%, which is $1,300.00). Use the data in these tables in order to show that bonds realize wide price fluctuations. The fourth column in the table presents the bond coupon rates. Explain the differences in prices between bonds with high coupon rates and those with low coupon rates with about the same maturities. Now find Treasury bonds with different maturities and about the same coupon rates. (You can push Next a few times.) Why are the prices of these bonds different?
2. Click on Bond Center. Click Bond Screener. Check Corporate, then on Find Bonds. Click Next about 5 times. Find a company that has at least 2 bonds listed (you might have to click back or next a few times) and explain why the bonds of the same borrower have different market prices.
3. Find another bond from a well-known company. Assume that the price of this bond was $800 (80) the year before. Explain to the “unhappy citizen” why the price of this specific bond today is different from its price last year.
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