Question

1. How can one find the market price of a bond given its yield to maturity or find a bond’s yield given its price? Why do prices and yields vary inversely?
2. Why do bonds exhibit interest rate risk?
3. How can stock valuation formulas be used to infer the expected rate of return on a common stock?
4. How does competition among investors lead to efficient markets?

Answer 1

Q. 1). The following formula may be used to calculate yield to maturity on bond :-

Yield to maturity = [ Coupon amount + (Face value of bond - Bond price) / Number of Years to maturity ] / (Face value of bond + Bond price) / 2

If the bond price increases then yield on bond will decrease because the interest rates on bond will fall in such case and if the bond price decreases then yield on bond will increase because the interest rates on bond will rise in such case, accordingly, bond yield and bond price vary in inverse manner..

Q. 2). Interest rate risk is associated with bonds due to unexpected change in interest rate in the case of bond because with the increase in interest rate on bond, its price will fall and vice-versa.

Q. 3). Value of stock = Expected dividend at end of Year 1 / (Expected rate of return - Dividend growth rate)

Alternatively,

Expected rate of return on stock = (Expected dividend at end of Year 1 / Value of stock) + Dividend growth rate.