Reference no: EM131449923
Dave and Marlene Carter live in the Boston area, where Dave has a successful orthodontics practice. Dave and Marlene have built up a sizable investment portfolio and have always had a major portion of their investments in fixed-income securities. They adhere to a fairly aggressive investment posture and actively go after both attractive current income and substantial capital gains. Assume that it is now 2016 and Marlene is currently evaluating two investment decisions: one involves an addition to their portfolio, the other a revision to it.
The Carters’ first investment decision involves a short-term trading opportunity. In particular, Marlene has a chance to buy a 7.5%, 25-year bond that is currently priced at $852 to yield 9%; she feels that in two years the promised yield of the issue should drop to 8%.
The second is a bond swap. The Carters hold some Beta Corporation 7%, 2029 bonds that are currently priced at $785. They want to improve both current income and yield to maturity and are considering one of three issues as a possible swap candidate: (a) Dental Floss, Inc., 7.5%, 2041, currently priced at $780; (b) Root Canal Products of America, 6.5%, 2029, selling at $885; and (c) Kansas City Dental Insurance, 8%, 2030, priced at $950. All of the swap candidates are of comparable quality and have comparable issue characteristics.
Questions
1-Regarding the short-term trading opportunity:
a-What basic trading principle is involved in this situation?
b-If Marlene’s expectations are correct, what will the price of this bond be in two years?
c-What is the expected return on this investment?
d-Should this investment be made? Why?
2-Regarding the bond swap opportunity:
a-Compute the current yield and the promised yield (use semiannual compounding) for the bond the Carters currently hold and for each of the three swap candidates.
b-Do any of the swap candidates provide better current income and/or current yield than the Beta Corporation bonds the Carters now hold? If so, which one(s)?
c-Do you see any reason why Marlene should switch from her present bond holding into one of the other issues? If so, which swap candidate would be the best choice? Why?
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