Question

consider a bond with a 6.2 percent coupon rate, paid semiannually, that has 20 years until it matures. If the current market interest rate is 7.4 percent, and the bond is priced at $925, what's the bond's present value? Should you buy this bond? Explain why or why not.

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Answer 1

Calculation of bond price:

	Particulars	Cash flow	Discount factor	Discounted cash flow
	Interest payments-Annuity (3.7%,40 periods)	31.0	20.7080	641.95
	Principle payments -Present value (3.7%,40 periods)	1,000	0.2338	233.80
A	Bond price			875.75
	Face value			1,000
	Premium/(Discount)			-124.25
	Interest amount:
	Face value	1,000
	Coupon/stated Rate of interest	6.20%
	Frequency of payment(once in)	6 months
B	Interest amount	1000*0.062*6/12=		31
	Present value calculation:
	yield to maturity/Effective rate	7.40%
	Effective interest per period(i)	0.074*6/12=		3.700%
	Number of periods:
Ref	Particulars	Amount
a	Number of interest payments in a year	2
b	Years to maturiy	20.0
c=a*b	Number of periods	40

Bond price should be $875.75 but it is trading at $925, which means bond is overpriced. To take advantage of the mispricing, bond should be sold.