USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The following information is given concerning a substitution swap. You currently hold a 15-year, 7 percent coupon bond priced to yield 8 percent. As a swap candidate you are considering a 15-year, 7 percent coupon bond priced to yield 8.5 percent. Assume a reinvestment rate of 8.5 percent, semiannual compounding, and a one-year workout period.

-Refer to Exhibit 13.5. The realized compound yield on the current bond is
A) 15.50%.
B) 11.03%.
C) 10.30%.
D) 8.01%.
E) 9.00%.

Question

USE THE INFORMATION BELOW FOR THE FOLLOWING PROBLEM(S)
The following information is given concerning a substitution swap. You currently hold a 15-year, 7 percent coupon bond priced to yield 8 percent. As a swap candidate you are considering a 15-year, 7 percent coupon bond priced to yield 8.5 percent. Assume a reinvestment rate of 8.5 percent, semiannual compounding, and a one-year workout period.
 
-Refer to Exhibit 13.5. The realized compound yield on the current bond is
A) 15.50%. 
B) 11.03%. 
C) 10.30%. 
D) 8.01%. 
E) 9.00%.

Quizplus · Accepted Answer

The realized compound yield on the current bond is the yield to maturity that will cause the bond's cash flows (coupon and principal payments) to have a present value equal to its price, assuming the investor reinvests all coupon payments at the same yield to maturity. Using the given information, we can solve for the realized compound yield using financial calculator or Excel. The answer is approximately 8.01%.

To determine the best choice, we need to compare the realized compound yield of the current bond to the yield of the swap candidate, which is 8.5%. Since the current bond has a lower yield, it would not be wise to swap into the higher yielding bond as that would result in a lower realized compound yield. Therefore, the best choice is to stick with the current bond.