Question

Consider a bank who purchases corporate bonds with an intention to hold all loan assets to maturity. That is, the bank’s business model is not to trade the bond on a transient basis and sell them before they mature.

Consider a 3-year bond asset of the bank. The bond is issued with face value $1,000 and coupon interest rate 10%.

Required

(1) Assume the market interest rate for a similar risk-profile debt security is 8% throughout all the years from the initiation to the maturity of the bond. Prepare all journal entries related to the bond asset for the bank using the amortized cost method.

(2) Assume the market interest rate is 8% for the first year of the bond period, 12% for the second year, and 6% for the third. Prepare all journal entries related to the bond asset for the bank using the amortized cost method.

(3) Based on your attempt of the two questions above, discuss how interest rate fluctuations affect the earnings recognized in relation to the bond asset under the amortized cost method.

Answer 1

1.PV of the bond/Issue price= PV of the annual interests received+ PV of the bond maturity amount

Annual interest=1000*10%=100

This will be in the form of annuity of 100 for 3 year, market interest rate= 8%

PV of interest annuity= 100* PVOA(i=8,n=3)

                                     =100*2.57710=257.71

PV of the maturity amount=1000* PV factor of $1(i=8,n=3)

                                              =1000*0.79383= 793.83

So, bond issue price= 257.71+793.83= $1051.54=

Journal Entry

Date        Explanation                             Debit        Credit

Year 1     Investment in Bond             1051.54

                   To Cash                                                   1051.54

              (Being Bond Purchased at Premium)

Year 1     Cash                                         100     

               To Interest                                               82.82

                To Investment in Bond (51.54/3)          17.18

(Being Interest income of $100 adjusted by amortization of bond premium)

Year 2     Cash                                         100     

               To Interest                                               82.82

                To Investment in Bond (51.54/3)          17.18

(Being Interest income of $100 adjusted by amortization of bond premium)

Year 3     Cash                                         100     

               To Interest                                               82.82

                To Investment in Bond (51.54/3)          17.18

(Being Interest income of $100 adjusted by amortization of bond premium)

Year 4      Cash                             1000

                     To Investment in Bond        1000

2.

PV of the interest recieved is computed using sequential discounting

Year 1= 100/1.08= 92.59

Year 2= 100/(1.12)(1.08)= 82.67

Year 3= 100/(1.06)(1.12)(1.08)= 77.99

So, total PV of interest income= 92.59+82.67+77.99= 253.26

PV of the maturity amount= 1000/(1.06)(1.12)(1.08)= 779.93

So, Bond price= 1033.18

So, Premium paid =33.18 for 3 year.

So, premium alloacted every year= 11.06

Journal entry

Year 1 Investment in Bond 1033.18

Cash 1033.18

Year 1 Cash..Dr 100

Interest 88.94

Investment in Bond 11.06

Year 2 Cash..Dr 100

Interest 88.94

Investment in Bond 11.06

Year 3 Cash..Dr 100

Interest 88.94

Investment in Bond 11.06

Year 3 Cash 1000

To Investment in Bond 1000

3)With the fluctuation in market interest rates, the bond prices fluctuate. Under the amortisation method, the premium on thebond purchase is adjusted from the interest income each year so that the excess of amount paid over the face value is written off equally during the period held. When the market interest rates are lower than the bond interest, the bonds are more attractive to the investors and hence carry a premium.