Question

1. Consider a coupon bond that has a face value of $1,000, a coupon rate of 4%, and five years to maturity.
2. 1. What is the price of the bond if the yield to maturity on similar bonds is 6%?
3. 2. What should its price be the following year if the yield to maturity on similar bonds falls to 5%? Would this change in yields be a good thing or not if you purchased the bond one year earlier at the price you calculated in (a) above? Explain. How does this example relate to interest-rate risk?

Answer 1

Answer a)

Value of Bond =

Where r is the discounting rate of a compounding period i.e. 6%

And n is the no of Compounding periods 5 years

Coupon 4%

=

= 168.494551446 + 747.25817283

= 915.75

Answer b)

Value of Bond =

Where r is the discounting rate of a compounding period i.e. 5%

And n is the no of Compounding periods 4 years

Coupon 4%

=

= 141.838020176 + 822.70247478

= 964.54

When the interest rate falls the value of Bond increases i.e. the YTM and the value of Bonds are inversely related.

So, if the bons was purcahsed one year earlier, it will be a good thing.

Also, the Interest Rate risk is the risk that the intrest rate will increase in the Future and will make the value of Bond go down as increase of interest makes the Bond unattractive which makes the value of Bond fall. That is the interest rate risk.