Question

HJK savings has purchased a corporate bond at a price of K98.71. The bond has a coupon rate of 6% and pays coupon interest annually. The bond has a par value of K100.00 and is redeemable at this par value in five years time. it is expected that the required rate of return on these bonds will 5% in two years time

a) Assuming that HJK ltd will sell this bond in two years time, calculate what the sale price would be.

b) Assuming that HJK savings Ltd will sell this bond in two years time, calculate the annualised yield on the bond over the next two years

c) Assuming that the required in two years time of 5% was overstated

i) how would the actual selling price differ from the forecast price calculated above

ii) How would the actual annualised yield over the next two years differ from the forecasted yield.

Answer 1

(a) Price = K 98.71, Coupon Rate = 6 %, Coupon Frequency: Annual, Par Value = HK 100, Required Return = 5 % , Tenure = 5 years

The bond is planned to be sold after 2 Years.

Annual Coupon = 0.06 x 100 = $ 6

Sale Price After 2 Years = 6 x (1/0.05) x [1-{1/(1.05)^(5)}] + 100 / (1.05)^(5) = HK 104.33

(b) Sale Price = HK 104.33 and Purchase Price = HK 98.71

Reinvested Value of Coupons = 6 x (1.05) + 6 = 12.3

Holding Period Return = [(12.3+104.33) / 98.71]^(1/2) - 1 = 0.08698 or 8.698 % ~ 8.7 %

(c) (i) The sale price of the bond after 2 years is equal to the total present value of the bond's remaining cash flows discounted at the required rate of return. If the required rate of return is overstated then the total present value of the bond's remaining cash flows will be higher and consequently the bond's price will also be higher.

(ii) The annualized yield for two years will be higher if the required return is overstated because a lower required return increases the sale price even though reducing the reinvestment income from coupons. A higher sale price and a not so low reinvestment income increases the overall annualized yield.