Question

b. If the market price of the bond is $1,050, do you buy or sell the bond? Why?

Answer 1

Solution: Based on market price alone we cannot determine, whether to buy or sell the bond. To determine buying or selling we need coupon rate, maturity value, par value & required rate of return.

lilustrated below with following details:

Assumtions: par value of bond=$1,000 coupon rate=10%per annum, coupon payable semi-annually, maturity = 2years,required rate of return(r)=6%per annum or 3% per 6month.

Coupon = 1000*10%/2 = $50 Redemption value = $1,000

Price of the bond = [Coupon for period 1/(1+r)]+[Coupon for period 2/(1+r)^2]+[Coupon for period 3/(1+r)^3]+[{Coupon for period 4+Redemption value}/(1+r)^4]

= [50/(1+0.03)]+[50/(1+0.03)^2]+[50/(1+0.03)^3]+[(50+1000)/(1+0.03)^4]

= (50/1.03)+[50/(1.03^2)]+[50/(1.03^3)]+[1050/(1.03^4)]

= 48.54+(50/1.0609)+(50/1.092727)+(1050/1.12550881)

= 48.54+47.13+45.78+932.91

= $1,074.36

If above is the situation, ond is underpriced hence recommended to buy.