Question

  You own a bond that pays ​$100 in annual​ interest, with a ​$1000 par value. It matures in 15 years. The​ market's required yield to maturity on a​ comparable-risk bond is 12 percent. a.  Calculate the value of the bond. b.  How does the value change if the yield to maturity on a​ comparable-risk bond​ (i) increases to 15 percent or​ (ii) decreases to 8 ​percent? c.  Explain the implications of your answers in part b as they relate to​ interest-rate risk, premium​ bonds, and discount bonds. d.  Assume that the bond matures in 5 years instead of 15 years and recalculate your answers in parts a and b. e.  Explain the implications of your answers in part d as they relate to​ interest-rate risk, premium​ bonds, and discount bonds.

Answer 1

c. As the interest rate increases in the market the value of the bond will go down. As the new opportunity arises, other things remains same, the investor will choose to invest in the more rewarding option. Hence the bonds price will come down and the vice versa happens when the market rates falls. A premium bond one which trades above it's face value because of it's higher interest rates and a discount bond is one that trades below it's face value due to coupon offered by it is below the market interest rate. Hence Market interest rates play a big role in determining the bond price.

d. As we saw in question C the interest rates play a big role in determining the bond price the time to maturity also plays a role. The volatility of bond price to long duration bonds are higher than the short duration bonds. Hence the bonds with longer maturity tend to have more risk and the short ones have less risk. As maturity becomes less and market rates falls the bond will become more dearer and vice versa when the rates increase, but still with lesser maturity the price will be higher than the long duration bonds