Question

7. Pat pays $10,000 for a newly issued two-year government bond with a $10,000 face value and a 6 percent coupon rate. One year later, after receiving the first coupon payment, Pat sells the bond. If the current one-year interest rate on government bonds is 5 percent, then the price Pat receives is:

A. $10,000.

B. $500.

C. greater than $10,000.

D. less than $10,000.

8. Sydney purchases a newly-issued, two-year government bond with a principal amount of $10,000 and a coupon rate of 6% paid annually. One year before the bonds matures (and after receiving the coupon payment for the first year), Sydney sells the bond in the bond market. What price (rounded to the nearest dollar) will Sydney receive for his bond if the prevailing interest rate is 5%?

A. $9,524

B. $10,000

C. $10,095

D. $10,600

9. One year before maturity the price of a bond with a principal amount of $1,000 and a coupon rate of 5% paid annually fell to $981. The one year interest rate:

A. rose to 8.5%.

B. rose to 7.0%.

C. rose to 6.0%.

D. remained at 5%.

10. When Federal Reserve actions cause interest rates on newly issued bonds to decrease from 6% to 5%, the prices of existing bonds:

A. increase.

B. decrease.

C. remain unchanged.

D. decrease only if the coupon rate is less than 5%.

Answer 1

8]

C] $10,095

Annual coupon = $10,000 x 6% = $600

Current price of the bond ($) = Present value (PV) of future cash flow

= PV of coupon + PV of redemption value (Face value)

= (600 + 10,000) / 1.05

= 10,600 / 1.05

= 10,095

9]

B] rose to 7.0%.

One-year interest rate (R) = [C + (F - P) / N] / [(F + P) / 2], where

C: Annual coupon = $1,000 x 5% = $50,

F: Face value = $1,000,

P: Market price = $981,

N: Years left to maturity = 1

So,

R = [50 + (1,000 - 981) / 1] / [(1,000 + 981) / 2]

= [50 + 19] / (1,981 / 2)

= 69 / 990.5

= 0.07

= 7%

10]

A] Increase

When Federal Reserve actions cause interest rates on newly issued bonds to decrease from 6% to 5%, the prices of existing bonds increase. This is because there is an inverse relation between bond prices and interest rates. The reason being that consumers would want to buy the bond with the higher interest rate. This will push the demand for existing bonds up and demand for new bonds down.