Question

Bond value and time-Changing required returns  Personal Finance Problem   Lynn Parsons is considering investing in either of two outstanding bonds. The bonds both have ​$1,000 par values and 12​% coupon interest rates and pay annual interest. Bond A has exactly 6 years to​ maturity, and bond B has 16 years to maturity.   a.  Calculate the present value of bond A if the required rate of return​ is: (1) 9​%, ​(2) 12​%, and​ (3) 15​%. b.  Calculate the present value of bond B if the required rate of return​ is: (1) 9​%, ​(2) 12​%, and​ (3) 15​%. c. From your findings in parts a and b​, discuss the relationship between time to maturity and changing required returns. d.  If Lynn wanted to minimize interest rate​ risk, which bond should she​ purchase? ​ Why?

Answer 1

Bond	r = 9%	r = 12%	r = 15%
A	.	.	.
B	.	.	.

Part C) From the above PV calculations we can see that till the time the interest rate is below the coupon rate, the bond with higher number of years to maturity has a greater PV and when the interest rate becomes higher than the coupon rate the bond with less number of years to maturity has higher PV.

Part D) Factors of interest rate risk are the following:

1. Bonds with higher coupon payment has lower interest rate risk as at each coupon date, some amount of initial investment is recovered. So the bond with higher coupon recovers more per coupon period. As both bonds have same coupon payment, this factor doesn't affect interest rate determination here.
2. Bonds with longer maturity have higher interest rate risk, because they are exposed to greater number of fluctuations in the interest rate risk. So here bond B is riskier.
3. Bonds with embedded call options are less sensitive to interest rate risk. As both the bonds are not embedded so even this fact has no impact.

So to have lower interest rate sensitivity, Lynn should select Bond A