Question

Suppose for $1,000 you could buy a 10%, 10-year, annual payment bond or a 10%, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If $1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond?

Answer 1

It is preferred to buy semi-annual bond as payments are received in advance compared to annual bond.

Effective interest rate = (1+10%/2)^2-1 = 10..25%

Price of annual payment bond will be:

Particulars	Cash flow	Discount factor	Discounted cash flow
present value Interest payments-Annuity (10.25%,10 periods)	$                       100.00	6.07913	$                607.91
Present value of bond face amount -Present value (10.25%,10 periods)	$                    1,000.00	0.37689	$                376.89
Bond price			$                984.80

Price of annual bond will be $984.80