Question

8.You buy a bond with $1,000 face value, 2 years to maturity and a 5% coupon rate.
The market interest rate is 6%. What price are you willing to pay?

After 1 year, you cash in the coupon payment, and you sell the bond again. Market interest rates are now 3%. What price can you now sell the bond for?

What is your rate of return after 1 year?

Question options:

	Buying price: About $981.67 Selling price: $981.67 Rate of return: About 5.10%
	Buying price: $981.67 Selling price: $1,019.42 Rate of return: About 8.78%
	Buying price: $981.67 Selling price: $1,019.42 Rate of return: About 8.94%

Answer 1

Face value = 1000

Coupon rate = 5%

Coupon payment = 5% * 1000 = 50

Maturity = 2 yrs

Market rate = 6%

Present value of bond = 50*(P/A,6%,2) + 1000*(P/F,6%,2) = 50*1.83339 + 1000*0.88999 = 981.67

After 1 year, market rate drops to 3%

Selling price = 1050/1.03 = 1019.417 = 1019.42

Let rate of return be i%

Total amount received from bond = 50 + 1019.42 = 1069.42

Buy value = 981.67

Using formula P = F /(1+i)^t

981.67 = 1069.42 / (1+i)

i = 1069.42 / 981.42 - 1 = 1.089388 - 1 = 0.089388 = 8.94%

Last option is correct