Question

An investor has the following two options:

1. To buy a two-year $1,000 zero-coupon bond at a market price of $860, or:
2. To buy a two-year $1,000 bond with an annual interest of 3% at a market price of $900.

Assuming annual coupon payments, which option do you think the investor should choose? Explain why.

Answer 1

a. Yield is computed as follows:

= (Par value / Market price) ^{1 / n} - 1

= ($ 1,000 / $ 860) ^{1 / 2} - 1

= 7.83%

b. The yield is computed as follows:

Plug the below variables in the financial calculator as follows:

FV = 1,000

PV = - 900

PMT = 30 (3% x 1,000)

N = 2

Finally press CPT and then I/Y. It will give I/Y equal to 8.66% Approximately

You can also use the below excel as follows:

= RATE(N,PMT,PV,FV)

= RATE(2,30,-900,1000)

It will also give I/Y equal to 8.66%

So, option b is preferred since the yield is higher.

Feel free to ask in case of any query relating to this question