Question

You own a bond that pays $100 in annual interest, with a $1,000 par value. It matures in 10 years. Your required rate of return is 11 percent.

a. Calculate the value of the bond.

b. How does the value change if your required rate of return (1) increases to 16 percent or (2) decreases to 7 percent?

c. Explain the implications of your answers in part b as they relate to interest rate risk, premium bonds, and discount bonds.

d. Assume that the bond matures in 3 years instead of 10 years. Re-compute your answers in part b.

e. Explain the implications of your answers in part d as they relate to interest rate risk, premium bonds, and discount bonds.

Answer 1

COMPUTED USING EXCEL

	FV	1000
	COUPON	100
	TIME	10
	YTM	11%
a)	value of bond	941.108		=PV(11%,10,100,1000)
b)1	increase to 16 %	710.006		=PV(16%,10,100,1000)
b)2	decrease to 7%	1210.707		=PV(7%,10,100,1000)
c)	WHEN YTM IS 16% IT IS TRADING AT DISCOUNT AS YTM>COUPON RATE ,SO ITS A DISCOUNT BOND
	WHEN YTM IS 7% IT IS TRADING AT PREMIUM AS YTM
	FV	1000
	COUPON	100
	TIME	3
	YTM	11%
d)	value of bond	₹ 975.56		=PV(11%,3,100,1000)
	increase to 16 %	865.247		=PV(16%,3,100,1000)
	decrease to 7%	1078.729		=PV(7%,3,100,1000)
e)	WHEN YTM IS 16% IT IS TRADING AT DISCOUNT AS YTM>COUPON RATE ,SO ITS A DISCOUNT BOND
	WHEN YTM IS 7% IT IS TRADING AT PREMIUM AS YTM
	AS THE LIFE IS LOWER BOND WILL HAVE LOWER INTEREST RATE RISK COMPARED TO HIGHER MATURITY BONDS WE CAN SEE THE 2 RESULTS , THE PRICE CHANGES IS SMALLER IN CASE OF LOWER MATURITY BONDS