Question

2. A high-yield bond with the following features:

Principal                                $1,000

Coupon                                  8%

Maturity                                 7 years

Special Features                  company may extend the life of the bond to 14 years

The current interest rate is 6%.

a) If you expect that interest rates will be 8 percent five years from now, how much would you currently pay for this bond?

b) What is your potential gain or loss if you buy the bond based on that expectation but interest rates are 10 percent five years from now?

Answer 1

Principal or FV = 1000

Coupon = 8%

So PMT = 80

Maturity N = 7 years

I/Y = 6%

CPT PV using the financial calculator

PV = 1111.64

a.)

After 5 years

N = 2

I/Y = 8%

Since I/Y becomes equal to the coupon rate the PV = Par value = 1000

b.)

If we purchase the bond on the expectation that company might extend the life of bond to 14 years

After 5 years,

N = 9 (14-5)

I/Y = 10%

PMT = 80

FV = 1000

CPT PV in the financial calculator

We get PV = 884.81

If we would have purchased the bond 5 years before we would have to pay the initial PV of $1111.64

But now we have to pay 884.81.

So gain = 1111.64 - 884.81 = 226.83