Question

Define coupon and market/effective interest rates as they determine bond pricing at par, premium, or discount values.

Answer 1

Coupon interest is the stated interest rate on the face value or par value of the bond. For example: 5% $500,000 bonds issued and interest payable annually would have annual interest payment of $25,000 ($500,000 *5%).

Market interest rate is the rate of interest prevailing in the money market.

Market interest rates determine the cash received from the issue/sale of bonds. The relationship between coupon interest rate and market interest rate is given below:

· If market rate of interest is same as coupon interest, bonds are issued at par since cash proceeds received from sale of bonds will be equal to face value of bonds.

· If market rate of interest is lower than coupon interest , bonds are issued at premium since cash proceeds received from sale of bonds will be higher than face value of bonds

· If market rate of interest is higher than coupon interest, bonds are issued at discount since cash proceeds received from sale of bonds will be lower than face value of bonds