Question

The price of a two-year 6% coupon bond was $100 on January 27

company issued a press-release where it announced that the previous CEO would resign and would be replaced by a more experienced one. That day the YTM of the bond became 5%, while on January 29th and afterwards the YTM reached 4%.Calculate the prices of the bond on January 28 and 29 . For simplicity of calculations ignore small

changes in time to maturity.

Plot the graph of the price dynamics (price on the Y axis and time on the X axis) on the date of the announcement and on the days following the announcement. Plot and explain the graph of the prices that you expect to see if the market was perfectly semi-strong form efficient. What is the name of the effect that you observe?

help to solve

Answer 1

Given:- Coupon rate=6% ,Face Value of Bond=$100

Lets first understand some common terms used in this question:-

Yield to maturity(YTM)=Total return expected on a bond if the bond is held till maturity.

Coupon rate=Interest rate on Bond calculated at Face Value always usually fixed throughout the bond period.

NOW,

Current yield of Bond=Face Value*Coupon Rate

=100*6%=$6

Yield=Interest/Market Price

Jan 27:-Price of Bond=$100 (As in case of Par value Bond ,YTM=Coupon Rate=6%)

Jan 28:- YTM of Bond falls to 5% ;Price of Bond(B0)=

YTM= Interest/Market Price

5%(Given) = 6/Market Price

Market Price=$120

Jan 29:- YTM of Bond falls to 4%

YTM= Interest/Market Price

4%(Given) = 6/Market Price

Market Price=$150

Note:- It is clear as Price of Bond increases ,Yeild to maturity decreases and vice-versa.

Semi strong form efficient market is a type of efficient market hypothesis which holds that security prices adjust quickly to newly available information ,thus eliminating the use of fundamental or technical analysis to achieving a higher return.

In this case prices of bond will reflect all publicly available information and that prices instantly change to reflect new public information.

The graph will be same as above  in the below cases:-

• On the date of announcement:-

as market is semi strong efficient market ,prices of bond will change with public information.

• On the date following the announcement

Prices will remain same as no further information is made public by the company.

2. As the bond prices is on rise Interest rate risk is there. As interest rates and bond prices have inverse relationship ,as interest rate falls ,the prices of bond trading in the market place generally rises.Conversely when interest rate rise,the bond prices fall. This happens because when interest rates are on rise ,investors will naturally jettison bonds that pay lower interest rates .This would force bond prices down.