Consider a two-year debt instrument with a face value of $5,000 and an annual coupon payment...

Consider a two-year debt instrument with a face value of $5,000 and an annual coupon payment of $125. Suppose prevailing interest rates in the economy are 1.0%.

a. Calculate the predicted price of this instrument. Does it sell for more (a premium) or less (a discount) than $5,000?

b. Calculate the nominal yield of this bond. How does it compare to the prevailing market interest rate of 1.0%? How does this comparison relate to whether the bond is sold at a premium or discount?

c. Calculate the current yield on this bond. Is the current yield higher or lower than the nominal yield?

Expert Solution

Qa) Calculation of predicted price of the instrument:

Given

Face value = $5,000.

Annual Coupon Payment = $125 and

Interest Rate = 1.0%

Hence, P = $125(1 + 0.4) + $125(1 + 0.4) + $5,000(1+0.4) = $4,858.54.

To conclude, we can say that the instrument gets sold at a discount rate.

Qb) The Nominal yield of the bond is $4,858.54.

Qc) The current yield on the bond is $4.858.54 and it is equal to nominal yield.

Rahul Sunny answered 2 years ago

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