Question

2. The effect of the coupon rate and the face value of a bond

Galego & Alden Corporation issues a 15-year bond with a fixed coupon rate of 3%. Suppose, that the inflation rate over the period is 7%. In 15 years, Galego & Alden ____________ (in real terms will benefit / in real terms will be financially unaffected / in real terms will suffer) because:

A- Inflation increases the real value of the coupon payments by the same amount as it decreases the value of the principle payment

B- Inflation decreases the real value of the coupon payments and the principle

C- Inflation decreases the real value of the coupon payments by the same amount as it increases the value of the principle payment

D- Inflation increases the real value of the principle, whereas the value of the coupon payments does not change

Ceteris paribus, which of the following follows from the situation described in the previous question?

A- Both borrowers and lenders are worse off because the coupon rate on a bond and the face value of a bond do not change.

B- Generally, borrowers benefit from the fact that neither the coupon rate on a bond nor the face value of a bond change over the life of the bond.

C- Both borrowers and lenders are better off because the coupon rate on a bond and the face value of a bond do not change.

​​​​​​​D- Generally, the lenders benefit from the fact that neither the coupon rate on a bond nor the face value of a bond change over the life of the bond.

Answer 1

1. Galego & Alden in real terms will benefit because Inflation decreases the real value of the coupon payments and the principle.

(higher inflation means higher money supply in the economy, thus fixed rate can be easily paid)

2.  Generally, borrowers benefit from the fact that neither the coupon rate on a bond nor the face value of a bond change over the life of the bond.

The borrower benefit because it has to pay fixed coupon payment to the lender even when inflation is double the coupon payment each year.

For example, suppose there is 100 $ bond with 3% coupon maturing in 15 years.

so the value that we will get after 15 years is = Bond value * (1 + 3%)^15 = 100 * (1 + 0.03)^15

= 155.79 $ (this is the amount we will get after 15 years at 3% rate)

But inflation is 6%,so suppose the bond is paying at inflation rate

The amount we will get after 15 years = 100 * (1 + 6%)^15

= 239.65 $ (This is the amount we will get it the interest rate matched with the inflation rate)

so here the lender is in worse off situation as he needs 239.65 $ after 15 years to maintain the same purchasing power with 6 % inflation rate. (155.79$ - 239.65 $ = - 83.86 $ loss in purchasing power )

borrower benefit at lower rate as the company has to pay only 3 % (239.65 $ - 155.79 $ = 83.86 Benefit )