Question

Your friend Michael is interested in learning more about bonds.

a. Explain to Michael the meaning of a bond, at least three types of bonds that are available, and the key features of a bond.

b. Explain to Michael the meaning of a zero coupon bond and what is meant by a premium and a discounted bond.

c. In general, how is the price of a bond calculated (not the market value)?

d. Assume a bond has a par value of $1000. What does that mean?

e. If a $1000 bond has an annual coupon of 6% and matures in 10 years, what should the price be? Assume similar bonds have a yield of 8%. Assume annual interest payments.

Answer 1

a) A bond is a fixed income security and is a type of debt instrument. Basically they are agreements between bond issuer and the one who has invested in that bond. They are loan agreements created with the purpose of raising money. Here the bond issuer is obligated to pay a specfic amount of cash at specific dates to its investors. The three types of bonds are

i)Government bonds : Issued by governments of country.

ii)Municipal bonds: Issued by states or municipalities

iii)Corporate bonds: Issued by companies

Key features of bonds are Issuer,Face Value,Coupon Rate, Coupon, Maturity, Yeild to Maturity, Market Value.

b)Zero coupon bonds are a type of bonds that does not pay any coupon. Here the person or institution who has invested in the bond recieves the face value of bond at maturity but does not recieve any coupon payments before maturity. Hence this bonds are called as zero coupon bonds. A bond is called discounted bond if it is trading below its par value. In case it trades above its par value it is called as a premium bond

c) The price of a bond is the sum of the present value of its future cash flow. So basically the cash flow for a bond is either from coupon payments or payment of face value at the time of maturity.

d) A bond having a par value of $1000 means that the issuer will pay this amount at maturity of the bond (usually along with coupons if any that are due)

e) As mentioned before the price of a bond is the PV of its future cash flow.

Year	Coupon	Maturity Amount
1	60
2	60
3	60
4	60
5	60
6	60
7	60
8	60
9	60
10	60	1000

PV of the above CF given yield of 8%

=60/(1.08) +60/(1.08)^2+60/(1.08)^3 +.....+60/(1.08)^10 +1000/(1.06)^10 = 865.7983