Consider a bond with a 10% coupon and with yield to maturity = 8%. If the...

Consider a bond with a 10% coupon and with yield to maturity = 8%. If the bond’s YTM remains constant, then in one year, will the bond price be higher, lower, or unchanged? Please explain your answer and give examples to help demonstrate your explanation.

Solutions

Expert Solution

If the yield to maturity of the bond is same as the coupon rate of the bond, then the bond is said to be trading at par value. If the bonds coupon rate is more than its yield to maturity then the bond is said to be trading at premium.

The value of the bond is the present of the future benefits discounted at expected rate of return.

Yield to maturity means what the bond gives the holder, if he holds the bond till maturity.

For Example, let us consider market value of a Rs.1000 bond which will mature after five years having coupon rate of 10% is 1500. then the yield to maturity of the bond can be calculated as below.

Approximate yield to maturity= Interest + Amortisation/ Average Price.

From our example,

Interest =1000*10%=100

Amortisation= (Issue price -Maturity value)/Life of bond.

= (1500-1000)/5

=100

Average Price= (Issue Price + Matruity value)/2

= (1500+1000)/2

=1250

Hence, Yield to maturity =100/1250

= 8%.

Conclusion: Since the bond is trading in the market at Rs: 1500 i.e., at premium of Rs: 500, the yield to maturity of the bond is less than the coupon rate.

In other words, If the coupon rate of the bond is more than its yield to maturity, then the bond is said to be trading at premium.

ekkarill92 answered 1 year ago

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