principles of fincnace week 7

Week 07 Example Problems

A $1,000 bond has a coupon of 6 percent and matures after 10 years. It pays semi-annual interest.

a. What would be the bond's price if comparable debt yields 8%?

b. What would be the price if comparable debt yields 8% and the bond matures after 5 years?

c. Why are the prices different in a. and b.?

d. What are the current yields and the yields to maturity of a. and b.?

Solution:

For the solutions to a and b, download the Week 07 Example Problem spreadsheet.

a. $864.10

b. $918.89

c. In both cases, the bond's price is less than par because the current rate of interest (that available for alternative investments) is greater than the rate paid on the bonds. (8% vs. 6%). However, the amount of the price decline is affected by the term of the bond, and the bond with the longer term experiences the larger price decline because the investors will collect the smaller interest payment for a longer period of time.

d. $60/$864.10 = 6.94% current yield and $60/%919 = 6.53% current yield. The yield to maturity is 8% in both cases.

Adapted from:

Mayo, H. (2007). Basic finance: An introduction to financial institutions, investments & management. United States: Thomson South-Western.