Imagine a bond that promises to make coupon payment of $100 one year from now and $100 two years from now, and to repay the principal of $1000 3 years from now. Assume also that the market interest rate is 8 percent per year, and that no perceived risk is associated with the bond.
Solution
a. Present value of bond= Present value of coupon payment year 1+Present value of coupon payment year 2+Present value of principal repaid year 3
Present value formula= Cashflow/(1+r)^n
where
r= rate of discounting=8% in this case
n= year of cashflow
Present value of bond=100/(1+.08)^1+100/(1+.08)^2+1000/(1+.08)^3
Present value of bond=972.1587
b. Now if the bond is offered at 1100 ,it is advisable not to buy the bond as the return of the bond will fall below the market interest rate of 8% if bought at 1100.
If the bond is bought at 1100, the price of the bond will fall in near future term as the market interest rates will be higher than return on the bond,thus correspondingly the market price of bond will fall
c. If the bond is offered at 930, the return on the bond will be higher than that of the market interest rate ,thus it is advisable to buy the bond at 930
Since the return of the bond is higher than market interest rate,in the near term the price of the bond will increase so that the market interest rate come in equilibrium with the return on bond
d. In tis case Price of bond=100/(1+YTM)^1+100/(1+YTM)^2+1000/(1+YTM)^3
Where YTM=Yield to maturity
Now if the price increases the Yield will decrease ,as it can be seen from the above equation that YTM is inversely propotional to Market price of bond
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