(Expected rate of return) Assume you own a bond with a market value of $1,050 that...

(Expected rate of return) Assume you own a bond with a market value of $1,050 that matures in 7 years. The par value of the bond is $1,000. Interest payments of $25 are paid semiannually. What is your expected rate of return on the bond?

Solutions

Expert Solution

Answer: Current price = 1050

Time for maturity = 7 years

Par value = $1000

Interest payments = $25 Semiannually

D is the discount rate taken semiannually

Rate of return for whole year would be = 2 * D

Cash Flow situation will be like this

	0	1	2	3	4	5	6	7	8	9	10	11	12	13	14
Cash Flow	-1050	25	25	25	25	25	25	25	25	25	25	25	25	25	1025

time interval in the first row are placed at 6 months interval

at the end of the 7th year we will get $1000 and $25 in total $1025

Now there are two ways to calculate the rate of return

1. use the IRR formula for the cash flow in the excel you will get the return at which it is 0 directly

Rate of return semi annually D = 2.085%

Annual rate of return = 2.085% * 2 = 4.16%

2. use present value formula = cash flow/(1 + discount rate ) ^ (no of time period)

Use the try and error method to put different values of D so that present value becomes 0. it is time consuming and long.

Answer is expected rate of return is around 4.16%

jeff jeffy answered 1 year ago

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