Question

Part a.

Explain why bond price and interest rates are negatively related. What is the role of coupon rate and term to maturity in this relationship?

                                                                                                                       

Part b.

Consider a 3-year bond with 14 percent semi-annual coupon payments and currently priced to yield 12 per cent per annum.

1. Calculate duration of the bond.

2. What is the percentage of price change if interest rate increases to 12.15% per annum?

                                                                                                           (7+3=10 marks)

Part c.

	Bond A	Bond B
Price	$924.18	$950.26
Market yield	10%	10%
Coupon rate	8%	8%
Maturity	5 years	3 years
Duration	4.282 years	2.777 years

Based on above information, which bond is more sensitive to changes in the interest rate? Explain your answer.

                                                                                                                       

Answer 1

a.All else being equal, if new bonds are issued with a higher interest rate than those currently on the market, the price of existing bonds will decline as demand for those bonds falls. Equally, if new bonds are issued with a lower interest rate than bonds currently on the market, the price of existing bonds will increase in line with demand.

The degree to which a bond’s price will change given any shift in interest rates is calculated by assessing the present value of the bond’s future cash flows. This is because traders use a method known as discounted cash flow to value a bond according to the future returns that they could expect.

If an investor purchases a at​​​​​ bond par or face value, the yield to maturity is equal to its coupon rate. If the investor purchases the bond at a discount, its yield to maturity will be higher than its coupon rate. A bond purchased at a premium will have a yield to maturity that is lower than its coupon rate.q