Question

In: Economics

On October 15, 2016, Koala, Inc. issued a 10 year bond (with a typical $1000 face...

On October 15, 2016, Koala, Inc. issued a 10 year bond (with a typical $1000 face value) that had an annual coupon value of $60. [We are assuming that the 2020 coupon has just been redeemed.]

• Initially, the bond was sold for the premium price of $1,025.

• On October 15, 2020, this bond was selling for only $975.

• The market rate of interest for a riskless corporate bond, of this maturity, was 4.5% on October 15, 2016, which reflects market expectations about future rates of inflation.

• The market rate of interest for a riskless corporate bond, of this maturity, was 4.0% on October 15, 2020, which reflects market expectations about future rates of inflation.

Question: It is now October 15, 2020 and suddenly the Federal Reserve announces a massive program to reduce inflation. Instantly, the market rate of interest for a riskless corporate bond that would apply to this bond, falls from 4.0% to 2.5%. If there is no change in the risk premium expected for this Koala, Inc. bond, what will be this bond’s yield to maturity?  [To 3 decimal places.]

Solutions

Expert Solution

Current yield = (Annual Coupoun payment / Bond Price) * 100

Oct, 2016 , Current yield = (60/1025) *100 = 5.85% and market interst was 4.5% ; so future inflation is expected as people would spend in 5.85% bond yield.

Oct 15, 2020, Current yield =(60/975) * 100 = 6.154% and market interest was 4% so again inflation is expected as demand for it increases.

To control inflation market rate of interest falls from 4% to 2.5%; buyers would stop buying as the return on bonds would be very less and the investor had to hold his bond until maturity.

Bond yield increases with the decrease in bond price; and as the bond price decreases interest rates becomes high as the investor tries to gain approximately same profit by increasing interest rate. So it can be said that as the interst rate increases, bond yield increases.

Now from 2020 to 2026, 6 years are left for maturity

So Bond yield to maturity at the end of 2026

= (( coupoun value + ((Face value- market price)/ time for maturity)) / ((FV +MP)/2)

=((60 +((1000-975)/6))/((1000+975)/2)

= 6.517%


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