Question

You have purchased a long-term coupon bond maturing in n periods selling for the price pn,t in the secondary market. You expect the Federal Reserve to raise the Federal Funds rate (interest rates) in the very near future. Should you sell your bond today or continue to hold on to it? What do you expect the price of the bond to be in one period? What do you expect to happen to the yield to maturity? What is your expected capital gain or loss if you hold onto the bond? What is the rate of return? Do you expect the rate of return to be positive or negative? Use the pricing equation in your answer to receive full credit.

Answer 1

Hi,

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Question;

Answer:

Bond is a debt instrument that is highly interest rate sensetive. When interest rate increase price of the bond decrease beacsue people sell the existing bond that offer comparetively low rate of retun. When interest rate decrease bond price increase. When price increase yield decrease and vice-versa. Long-term bond is more interest rate sensetive compare to short-term bond

Yield = (Coupon payment/ Market price)*100

Capital gain is is the difference between selling price and buying price

Capital gain = (Selling Price - Purchase Price)

Bond price = P(T0) = [PMT1 / (1 + r)^1] + [PMT2/ (1 + r)^2] … [(PMTn + FV) / (1 + r)^n]

Where,

P= Price

PMT= Coupon Payment

FV = Future Value, Par Value, Principal Value

r = Yield to Maturity, Market Interest Rates

n = Number of Periods

So, you can see higher r means lower the bond price and vice versa.

I expect the Federal Reserve to raise the Federal Funds rate (interest rates) in the very near future so, i will sell bond today. The price of bond will decrease due to expection of raise the Federal Funds rate (interest rates) in the very near future.

Yield to Maturity = [C + (F-P)/n]/F+P/2

Where C is the coupon interest payment, F is the face value of the bond, P is the market price of the bond, and "n" is the number of years to maturity.

Here P will decrease so YTM will increase.

I expected capital loss if you hold onto the bond due sharp fall in bond price. But if i hold till maturity then YTM will be higher.

Rate of retun = C + (P1-P0)/P0

P1 will decrease so rate of return will decrease. Rate of return will be negative in the most of the cases .

Thank You