Question

You are in a position where you decide to invest in bonds in the market place.  You are considering investing in the bonds of Able Corp.  Able Corp. bonds have a par value of $1,000 each and pay annual interest of 7% and mature in 25 years. Interest is paid semiannually.

1. The current annual rate of interest on bonds of similar risk in the market place is 8% annually.  This is also your required rate of return. What price should you pay for the bond?

2. Now assume that the market rate of annual interest and your required rate of return is 6%.  What price should you pay for the bond?

3. Describe two possible reasons that the market rates of a similar risk bond are different from the contractual rate of interest on the bond.

Answer 1

a. Par Value =1000
Semi Annual interest =7%*1000/2 =35
Number of Periods =25*2 =50
Semi annual YTM =8%/2 =4%
Price you should pay for the bond =PV of Coupons+PV of Par Value =35*((1-(1+4%)^-50)/4%+1000/(1+4%)^50 =892.59

b. Semi annual YTM =6%/2 =3%
Price you should pay for the bond =PV of Coupons+PV of Par Value =35*((1-(1+3%)^-50)/3%+1000/(1+3%)^50 =1128.65

c. Two possible reasons why similar risk bonds have interest rate different from the contractual rate of interest on the bonds:
1. The two bonds might have different liquidity .One Bond might be more liquid than the other. This might cause difference in the interest rates.
2. The credit rating agency rating might cause the market interest rate to be different from contractual rate of interest.