Question

What would you pay for a bond with a $10,000 maturity value, a $500 coupon payment and a 20 year term to maturity when your best alternative rate of return is r = .10. Compare this answer with the answer to the last question. Notice that if the interest rate increases, then the price that you'd pay for the bond decreases. This is because at the higher rate of interest, you would now need to invest less in the best alternative to match the return paid by the bond

Answer 1

Given for a bond,

Face value = $10000

coupon payment = $500

years to maturity = 20

rate of return = 0.1 or 10%

Price of the bond can be calculated on financial calculator using following values:

FV = 10000

PMT = 500

N = 20

I/Y = 10

compute for PV, we get PV = -5743.22

When interest rate in the market increases, Price of the bond decreases, this is because people will shift to higher interest paying bonds and this will reduce demand for this bond and so price will decrease. Also, at the higher rate of interest, you would now need to invest less in the best alternative to match the return paid by the bond