Question

(Bond valuation?) You own a bond that pays ?$100 in annual? interest, with a ?$1,000 par value. It matures in 10 years. Your required rate of return is 12 percent. a. Calculate the value of the bond. b. How does the value change if your required rate of return? (1) increases to 14 percent or? (2) decreases to 8 ?percent? c. Explain the implications of your answers in part ?(b?) as they relate to interest rate? risk, premium? bonds, and discount bonds. d. Assume that the bond matures in 3 years instead of 10 years. Recompute your answers in part ?(b?). e. Explain the implications of your answers in part ?(d?) as they relate to interest rate? risk, premium? bonds, and discount bonds.

Answer 1

a) Value of bond = 100/0.12*{1-1/(1.12)^10} + 1000/1.12^10 = 565.02+321.97 = 886.99

b) Value of bond = 100/0.14*{1-1/(1.14)^10} + 1000/1.14^10 = 521.61+269.74 = 791.35

Value of bond = 100/0.08*{1-1/(1.08)^10} + 1000/1.08^10 = 671+463.19 = 1134.19

c) As the interest rate reaches above the coupon rate then the bond becomes a discount bond whereas when the interest rate reaches below the coupon rate then the bond becomes a premium bond.

d) Value of bond = 100/0.14*{1-1/(1.14)^3} + 1000/1.14^3 = 232.16+674.97 = 907.13

Value of bond = 100/0.08*{1-1/(1.08)^3} + 1000/1.08^3 = 257.7+793.83 = 1051.53

e) As the bond reaches maturity the variation in its value from the face value keeps on decreasing.