Question

Assume that in March of 2019 you buy a bond issued by a corporation that has a face of $10,000 and a coupon rate of 5%. The bond will mature in March of 2022. Assume that you pay $10,500 for the bond.

2.a (3 points) Given that you paid $10,500 for the bond, what does this tell you about the market interest rate (the yield to maturity) on the coupon bond when you bought it?

2.b (4 points) Assume that you plan on selling the bond in March of 2020. Use a bond- pricing equation to illustrate the price that you will be able to sell the bond for in March of 2020. You do not have to solve the equation.

2.c (4 points) Assume that the corporation defaults in March of 2020 and pays you $9000 rather than the promised future cash flows. Briefly discuss the concept of the actual return earned on a debt instrument and how the corporation’s default has affected your actual return on the bond that you bought in 2019.

Answer 1

2 a: Using financial calculator

Input: FV= 10,000

N = 3

PV = -10500

PMT = 5%*10000 = 500

Solve for I/Y as 3.22

Hence the market rate is 3.22%

Since the bond is selling at a premium, it implies that the market rate is lesser than the coupon rate offered by the bond.

2 B: a bond price will be equal to the present value of coupons to be received till maturity plus the present value of the par value to be received in future.

Coupon = 5%*10000 = 500

Hence Price in March 2020 = C/(1+r)^1+ C/(1+r)^2 + FV/(1+r)^2

Price in March 2020= 500/1.0322^1 + 500/1.0322^2 + 10000/1.0322^2

2C: The actual return earned on an instrument may be different from the expected return. Like in this case the maturity value expected was $10,000 but only $9000 was received. Due to this the actual return will be lesser than the expected return. This is because the expected return was based on the present-value of future coupons plus the maturity value to be received after three years at the time of purchase.