Question

3. a. Write down the formula used to calculate the Present Value (PV) of a future Cash Flow (CF)  

for ‘n’ years. Using this formula, explain why the price of a coupon bond and the yield to maturity are negatively related.  

b. If there is an increase in interest rates, which would you rather be holding, long-term bonds or short-term bonds? Why? Which type of bond has the greater interest-rate risk?

Answer 1

A. Formula used to calculate for the present value of future cash flow=(cash flows/(1+interest)^n-initial investment)

n= total time period.

Price of the bond is negatively related to Yield to maturity, when will yield to maturity will be going up,it will be a representative that there will be higher interest rate which will be used for discounting of the bonds and it will be leading to lower price of the bond and the lower present value of the bond.

B. If there is an increase in the interest rate, that I will be trying to hold long term bonds and I will be trying to ensure that these interest rate are payable to me for the longer period of time.

those bonds who are having a longer maturity and those bonds who are also having a lower coupon rate are highly sensitive to the change in the interest rates.