Question

4) Explain (in no more than two paragraphs for each) which of the following statements are true or false.

A. Suppose two bonds of equivalent risk and maturity have different prices such that one is a premium bond and one is a discount bond. The premium bond must have a greater expected return than the discount bond.

B. All else equal, the holder of a fairly priced premium bond must expect a capital loss over the holding period.

C. The longer the time to maturity, the lower the security's price sensitivity to an interest rate change, ceteris paribus (all else equal).

Answer 1

A.

The relationship between price of bond and market interest rate is inverse. That is when interest rate rise, price of bond decreases and when interest rate falls bond price increase. Par value of bond is $1,000 and current price is $1,100. So this bond is a premium bond and so market rate that is yield to maturity bond must be lower than coupon rate.

So, if bond is trading at premium it mean YTM of bond must be lower than coupon rate and again if bond is trading at discount, it mean YTM of bond must be higher than coupon rate.

So, given statement is false.

2.

A premium bond means Price of bond must be more than Par value of bond. if YTM remains constant then price of bond contantly decreasing and move towards par value of bond. So, a fairly priced premium bond must expect a capital loss over the holding period.

So, given statement is true.

c.

There is direct relationship between Bond interest rate risk and maturity of bond. For long maturity bond the probability of interest rate is higher than for short term bond. So interest rate risk for long term bond is higher than short term bond.

Longer period bond higher interest rate risk.

Shorter period bonds lower interest rate risk.

So, Given statement is false.