Question

Consider a bond that promises to pay $100 in one year.

a.       What is the interest rate on the bond if the price of the bond today is $70? $80? $90?

b.       What is the relation between the price of the bond and the interest rate?

c.       If the interest rate is 10%, what is the price of the bond today?

Answer 1

a) IF the price of the bond is $70 then the interest rate on the bond is 30%.

IF the price of the bond is $80 then the interest on the bond is 20%.

If the price of the bond is $90 then the interest on the bond is 10%.

(A bond is always discounted on the interest rate it will pay. If the bond is paying an interest rate of say 50% and the par value of that bond is $100. Then that bond will be sold at a price of $50 and when discounted the holder will be paid $100. )

b) The price of the bond and the interest rate is inversely proportional. The higher the interest rate the lower the price of the bond will be i.e. they have a negative relation.

c) If the interest rate is 10% then the price of a bond with the par value of $100 will be $90.