Question

QUESTION 2 A zero coupon bond is purchased, and then yields on similar risk bonds decrease. The price of the bond will therefore increase.

True

False

Answer 1

Price of zero-coupon bond is the present value of face amount discounted with required interest yield and can be computed as:

Price of zero-coupon bond = Face value/ (1+ Interest yield) ^{number of periods}

Price of zero-coupon bond is inversely proportional with required rate of return. On decreasing the rate price increases and vice-versa.

We can consider an example:

Face value = $ 1,000; Interest rate = 0.09; Periods to maturity = 10

Bond price = $ 1,000/ (1+0.09)¹⁰

                   = $ 1,000/ (1.09)¹⁰

                   = $ 1,000/ 2.36736367459212

                   = $ 422.410806895689 or $ 422.41

If interest rate = 0.06,

Bond price = $ 1,000/ (1+0.06)¹⁰

                   = $ 1,000/ (1.06)¹⁰

                   = $ 1,000/ 1.79084769654285

                   = $ 558.394776915118 or $ 558.39

Bond price increased on decreasing the interest yield.

Hence the statement is true.