Question

Q3:

A 2 year bond with coupons at the end of each of its two years has face value 100 units and coupon rate of five per cent. Because the bond is a "safe refuge", during a period of uncertainty, its price is bid up.

a) Calculate, showing and briefly explaining your algebraic workings, to what level the (second hand market) price of the bond would need to rise in order that the yield received by a purchaser should fall to zero.

b) Carefully explain why bidders may be prepared to continue acquiring such the bonds, even if further market pressure causes it to return a negative yield.

Answer 1

YTM needs to be 0

YTM =[ Coupon + (Redemption value - Market price)/no. of years ] / (Redemption value + Market price)/2

Let market price be X

0 = [5 + (100-X)/2]

Denominator would become 0 as it is multiplied with 0

0 = 10 + 100 - X

X= 110

When the price is 110 YTM would be 0. Anything greater than 110 would lead to negative YTM.

2) As there is increase in demand of bond , YTM starts to reduce as bonds are safe assets . Even if bond is into negative yield trajectory , to keep the principal amount safe from value erosion as compared to other options , people start buying bonds . Government bonds are backed by government , and there is no chance that government could default in repayment of bond.