Question

Distinguish how a stated rate and the market rate of interest are calculated for a bond.

Answer 1

Solution:

Stated interest rate

  The stated interest rate of a bond payable is the annual interest rate that is printed on the face of the bond. The stated interest rate multiplied by the bond's face amount (or par amount) results in the annual amount of interest that must be paid by the issuer of the bond.(ie.,Nominal interest rate)

Market interest rate:

Market interest rates are likely to increase when bond investors believe that inflation will occur. As a result, bond investors will demand to earn higher interest rates. The investors fear that when their bond investment matures, they will be repaid with dollars of significantly less purchasing power.

Exampleof sated interest rate:

$10,000, one-year bond with a stated annual interest rate of 10% will earn $1,000 at maturity. If the money was placed in an interest-earning savings account that paid 10% compounded monthly, the account will earn interest at a rate of 0.833% each month (10% divided by 12 months; 10/12 = 0.833). Over the course of the year, this account will earn $1,047.13 in interest, at an effective annual interest rate of 10.47%, which is notably higher than the returns on the 10% stated annual interest rate of the certificate of deposit.

Formula: Face value of bond*interest rate*no.of months/12months

Example of market interest rate:

Calculate the Bond Yield

Look up the price you paid for the bond in your financial records. Divide the coupon rate in dollars by the purchase price of the bond and multiply the result by 100 to convert to a percentage interest rate. Suppose you paid $4,500 for a bond with face value of $5,000 and a coupon rate of $300.A