Question

Last year, Jimmy graduated  from First City  University and received USD 5,000 from his father as a graduation gift. Jimmy, , recently heard from a friend who earns a profit from investing in the bond market during this pandemic time.

JImmy does not know much about investing or how people actually “make money by investing”. He asked you to help him in making a wise investment plan.

Required:

1. Before investing any money, explain to Jimmy about the risk involved.

2. Calculate the expected rate of return Jimmy would receive if he buys bonds in Eplas bond. Eplas bond is a 15-year, USD1,000 par value bond that pays 5.5 percent interest annually. The market price of the bond is USD1,085.  

3. Determine the value of the bond given Jimmy required rate of return is 7 percent.

4. Jimmy’s father, Mr.Marc is valuing an investment that will pay him USD12,000 the first year, USD14,000 the second year, USD17,000 the third year, USD19,000 the fourth year, USD23,000 the fifth year, and USD29,000 the sixth year (all payments are at the end of each year). Determine the value of the investment to Mr.Marc now if the appropriate annual discount rate is 11%.

Answer 1

Major risks involved in investing in bonds are as follows:

(I ) Default risk or credit risk: The issuer may, over a period of time, make default in payment of interest and or repayment of the principal. This is more important as bonds are long term debt instruments and the paying capacity of the issuer might get affected during the course of time.

(ii ) Interest rate risk or market risk: It is the risk of fixed income securities being affected by change in the market. When the market interest rate (or consequently the market expectation of yield) increases, price of the bond gets reduced so that the fixed amount of income at the coupon rate corresponds to the higher yield expectation on. The reverse process takes place in case the market interest rates decrease after making the investment. In such a situation, price of the security increase when the market interest rate decreases.

(iii) Reinvestment risk is the risk of investors that the income generated not being able to be deployed at the same or better rate of return. This occurs in the event of the market interest rate declining so that the fresh avenues for further investment of the cash flows generated will be at the lower rates.

Value of the Eplab’s bond, with required rate of return of 7%= $863.38 as follows:

Value of investment to Mr. Marc at discount rate of 11%= $76,278.05 as follows: