Question

Mike Buys a corporate bond with a face value of $1000 for $900. The
bond matures in 10 years and pays a Coupon interest rate of 6%.
Interest is paid every quarter.

(a) Determine Defective rate of return if my cold is the born
to maturity.

(b) What Effective interest rate will Mike get if he keep the
bond for only 5 years and sells it for $950?

Answer #1

a)

Face Value = $1,000

Current Price = $900

Maturity in 10 years

Annual Coupon Rate = 6%

Quarterly Coupon Rate = 6% / 4 = 1.5%

Quarterly Coupon = 1.5%*$1,000 = $15

Let Quarterly YTM be i%

900 = 15*PVIFA(i%, 40) + 1,000*PVIF(i%, 40)

i = 1.86%

effective rate of return = (1 + 1.86%)^4 - 1

EAR = 1.0765 - 1

EAR = 0.0765 = 7.65%

effective rate of return = 7.65%

b)

Current Price = $900

Sold after 5 years at $950

Annual Coupon Rate = 6%

Quarterly Coupon Rate = 6% / 4 = 1.5%

Quarterly Coupon = 1.5%*$1,000 = $15

Let Quarterly YTM be i%

900 = 15*PVIFA(i%, 20) + 950*PVIF(i%, 20)

i = 1.89%

EAR = (1 + 1.89%)^4 - 1

EAR = 1.0777 - 1

EAR = 0.0777 = 7.77%

effective rate of return =7.77%

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