Jorge FuIIen is evaluating a 7% 10-year bond that is callable at par in 5 years. Coupon payments can be reinvested at an annual rate of 7%, and the current price of the bond is $106.50. The bond pays interest semiannually. Should Fullen consider the yield to first call (YTC) or the yield to maturity (YTM) in making his purchase decision?
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A. B. C.B
To determine whether Jorge Fullen should consider the yield to first call (YTC) or the yield to maturity (YTM) in making his purchase decision, we need to compare the two measures and understand their implications in this specific scenario.
Yield to maturity (YTM) represents the total return an investor can expect to receive if they hold the bond until its maturity date. It takes into account the bond's current price, coupon payments, and the final principal repayment. YTM assumes that all coupon payments are reinvested at the same yield rate until maturity.
Yield to first call (YTC), on the other hand, considers the potential return if the bond is called by the issuer at the first opportunity, which in this case is in 5 years. When a bond is callable, the issuer has the right to repay the bond before its maturity date. If the issuer decides to call the bond, the investor will receive the call price instead of the principal repayment.
Now, let's analyze the information given:
To determine whether YTC or YTM is more relevant, we need to assess the likelihood of the bond being called and the potential reinvestment opportunities for coupon payments.
If the bond is called, the investor will receive the call price at the end of 5 years, cutting the bond's remaining cash flows short. In this case, the remaining cash flows would only include the coupon payments for the next 5 years, as the bond will be called at par. Therefore, if the bond is called, the investor will receive the call price plus the reinvestment of coupon payments for the next 5 years.
If the bond is not called, the investor will receive coupon payments for the full 10-year maturity period, allowing for more reinvestment opportunities. The YTM calculation assumes all coupon payments are reinvested at the same yield rate until maturity.
Given that the yield rate for reinvesting coupon payments is 7%, which is the same as the coupon rate, the yield to first call (YTC) would be the same as the bond's coupon rate since coupon payments can be reinvested at the same rate. The YTC would be 7%.
Now, let's compare the YTC and YTM:
If the bond is called, the investor will receive the call price and the reinvested coupon payments for the next 5 years, resulting in a return equal to the YTC of 7%.
If the bond is not called, the investor will receive the remaining coupon payments for the full 10-year period and can reinvest them at a yield rate of 7%. The YTM would be calculated based on the current price of $106.50, the coupon payments for the full 10 years, and the final principal repayment.
Without further information on the bond's potential call risk, it is not possible to definitively determine whether YTC or YTM should be considered. However, based on the information provided, we can conclude that Jorge FuIIen should consider the yield to first call (YTC) in making his purchase decision because it represents the potential return if the bond is called and assumes reinvestment at the same yield rate.