Question

Paomi Inc. invested in a 5-year annual coupon bond two years ago. The face value of the bond is $1000 and the annual coupon rate is 6%. The interest rate (or the required rate of return) of the bond was 7% two years ago when Paomi purchased the bond. If the interest rate (or the required rate of return) of the bond goes down to 6.5% now, which of following is FALSE?

Group of answer choices

A) This example shows the effect of interest rate risk on Paomi’s assets.

B) The bond price now is $986.76.

C) The reinvestment return of the coupon is 6%.

D) A decrease in interest rate affects both bond price and reinvestment return of coupon.

Answer 1

The requires rate of return i.e. Yield goes down to 6.5% from 7%.

Since there is decrease in yield of the bond which means price of bond will increase as price of bond is inversly proportion to yield of bond. Also, The reinvestment return on coupon is the required rate if return i.e. yield on the bond.

Therefore this example shows the effect of interest rate risk on Paomi's asset. Aloso, decrease in interest rate affects both bond price and reinvestment return of coupon.

Hence option(A) and option (D) is True.

New Bond price:

P= 60/(1+6.5%) + 60/(1+6.5%)² + 1060/(1+6.5%)³

P = 56.3380 + 52.8996 + 877.5200 = 986.76

Hence option(B) is True.

The reinvestment return on coupon is the required rate if return i.e. yield on the bond. In this case reinvestment return on coupon is 6.5%. Hence, option(C) is FALSE