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%