Question

Suppose the U.S. government issues a two-year bond with a face value of $1,500 and a zero coupon.

(a)If yearly interest rates on bank deposits are 5 percent, would we expect the yield of the bond to be greater than, less than, or equal to 5 percent? Explain intuitively why this is the case.

(b)What will the market price of the bond be, given the yield? (Round to the nearest dollar)

(c)Suppose the bond is sold for the price you calculated in part (b). One day later, interest rates on bank deposits suddenly and permanently increases from 5% to 8%. What would the bond’s yield adjust to? Calculate the new price of the bond, given this yield, again rounding to the nearest dollar. Does the price of the bond increase or decrease? Explain intuitively why this is the case.

(d)Suppose the interest rate remains at 5% after you purchase the bond, but you believe the interest rate will be at 8% next year. What are you willing to pay for this bond? What if the bond has a 10% coupon?

Answer 1

(a) generally the bonds have an inverse relationship with the interest rates of the bank. When the interest increases, the cost of borrowing money will also increase which result in the fall in the prices of the bonds. In the above case the doctor the yield of the the bond would be higher than 5%.

(B) the current market price of the bond is determined using the current interest rate that is 5% plus the market value of the bond.

So in this case the market value of the bond would be $1500 Plus 5% that is 1575 dollars.

(C)

If the interest rate in the market increases, the market value of the bond. Would decrease.

because When the interest rate rises the market value of the bond falls.

(D) if the rate is constant but expected to increase the coupon rate of the bond will now seem less attractive for the investors and therefore the investor will be willing to pay less for the same bond.