Question

You bought a 5-year annual payment corporate bond with a market price of $1000. The bond pays annual interest of $100, by how much your bond is mispriced if

1. The required rate of return on your investment is 10%?
2. The required rate of return on your investment is 12%?

Answer 1

Hi

Assume that bond's face value F = $1000

So time t = 5 years

Price P = $1000

case a) required return = 10%

So Bond Price should be = (C/r)*(1-(1+r)^-t) +F/(1+r)^t

=(100/0.1)*(1-1.1^-5) +1000/1.1^5

=1000*0.379 + 620.92

=$1,000

Son for required rate of return of $10%, bond's price is correct.

b) r = 12%

So bond price should be = (100/0.12)*(1-1.12^-5) + 1000/1.12^5

=833.33*0.43 + 567.43

= 360.48 + 567.43

=$927.90

Hence bond price is higher by =1000-927.90

= $72.10

Thanks