You are buying right now a zero-coupon bond. It has exactly 8 years to maturity, and you expect the YTM to be 6% over the bond’s life. Even though you intended to hold it to maturity, you end up selling it after 3 years. By that time, the bond’s YTM has risen to 8% due to changes in market conditions.

Question

Your tax rate is 40% on regular income, and 15% on capital gains.

a) What is your annual average after-tax return for this bond over the three-year holding period? (8 Pts) (Note: Please do the calculation exactly, not as an approximation)

b) What would have been the bond’s price today under the initial YTM assumptions if the time to maturity were to be 7 years and 200 days rather than 8 years as stated above. What would be the accrued interest to be added to the purchase invoice? (5 Pts) (Note: Assume a 360-day year)

c) The result of the calculation in b) is either higher or lower than the result in a). Tell me whether it is higher or lower, and explain to me why it is. (3 Pts)

An EXCEL spreadsheet is very useful for these types of calculations.

Assume you have a bond that pays $100 after 8 years. Calculate how much one would pay for such a bond at 1) t=0 when YTM=6%, 2) t=5 and YTM=6%, and 3)t=5 when YTM=8%. As I understand, the difference between 1) and 2) is treated as ordinary income, and between 2) and 3) as a capital gain. (I presume you have the formula for converting YTM into market prices). You should have all the parts needed to answer a)

Part b seems to repeat part a cept for a shorter maturity.

I'd like to know it as well...:)