Question

Explain why a bond issued with a coupon rate of 6% is trading at a discount? par? premium? if the current market rate is 9%.? Choose one of the three - par, discount, premium

Answer 1

Answer)

The market value of a bond is the present value of all future cash inflows from the bond. If a bond has a coupon rate of 6% and the market rate of interest is 9%, the bond will be trading at a DISCOUNT. It is because the future value of cash inflows (coupon interest and face value) discounted at 9% will be lower than the face value of the bond.

In other words, the market rate of interest is 9% and since the bond is offering coupon rate of 6%, the bond is offering return less than the market rate of interest and will thus be issued at a discount.

For example: A bond having face value of $ 10,000 and Term 5 years. Coupon rate is 6% and market rate of interest is 9%. The market value or issue price of bond will be calculated as follows:

Issue price = (Face Value X Present value factor at 9% for 5^th year) + (Coupon payment X present value annuity factor at 9% for 5 years)

                     = ($ 10,000 X 0.64993) + [($ 10,000 X 6%) X 3.88965]

                     = $ 6,499.30 + $ 2,333.79

                     = $ 8,833.09.

Thus the bond having face value of $ 10,000 will be issued at $ 8,833.09 (i.e. at a Discount).