Question

3. Suppose that you buy a 5 year bond, with a face value of $2 000, a coupon rate of 2%, and a price of $1 908.41.

a. Calculate the yield to maturity of this bond. AFTER you buy the bond, market interest rates rise to 4%.

b. What will your rate of return be if your holding period is the full 5 years?

c. If you unexpectedly need to sell the bond at the end of the second year, what will your rate of return be?

d. Explain the concept of “interest rate risk” and why it means you probably shouldn’t buy bonds during the recovery phase of the business cycle.

Answer 1

a) YTM can be calculated using I/Y function

N = 5, PMT = 2% x 2000 = 40, PV = -1908.41, FV = 2000 => Compute I/Y = 3.00%

b) Your rate of return if you hold it for 5 years will be equal to YTM = 3.00%

c) Bond Price after the rate rose to 4% can be calculated using PV function

N = 3, PMT = 40, I/Y = 4%, FV = 2000 => Compute PV = $1,889.00

Your rate of return can be calculated using I/Y function

N = 2, PMT = 20, PV = -1908.41, FV = 1,889 => Compute I/Y = 1.59%

d) Interest rate risk is the risk that the bond price could fall when the interest rates rise. Hence, during the recovery phase of the business cycle, you shouldn't buy bonds because it is likely that interest rates would rise and bond prices would fall.