Question

Please provide examples of the following:

5. Calculate effective rate of interest and calculate stated rate in reverse. If I give you amount of interest and face value of bond, what is interest rate?

a. Stated rate: interest in $ divided by face value of a bond in $

b. Effective rate: divide effective interest in $ the outstanding (book value) balance of bond

Answer 1

Example of effective interest rate of bond

Say there is a 10-year bond with a face value of $2,000 that pays 5 percent interest every year and returns the principal when the bond matures. At 5 percent interest, the bond will pay $100 per year in interest. If the bond is being sold at a discount for $1,900, first subtract the sale price of $1,900 from $2,000 to find the bond is being sold at a $100 discount. Second, divide the $100 discount by the 10 annual payments remaining on the bond to get $10. Third, add the $10 to the $100 in interest the bond pays each year to get $110. Fourth, divide $110 by the average of $1,900 and $2,000, or $1,950, to get 0.0564. Finally, multiply 0.0564 by 100 to find the effective interest rate is 5.64 percent.

Stated rate example
Coupon rate is the rate of interest paid by bond issuers on the bond’s face value. It is the periodic rate of interest paid by bond issuers to its purchasers. The coupon rate is calculated on the bond’s face value (or par value), not on the issue price or market value. For example, if you have a 10-year- Rs 2,000 bond with a coupon rate of 10 per cent, you will get Rs 200 every year for 10 years, no matter what happens to the bond price in the market.