Amy purchased a 15-year bond at par value when it was initially issued five year

Question

Amy purchased a 15-year bond at par value when it was initially issued five years ago. The bond has an annual coupon rate of 6% and a par value of $1000. The current market interest rate (yield to maturity) is 4.25%. At the current market interest rate, this bond will sell at _______. Assuming no change in market interest rates, the bond will present the Amy with capital ________ as it matures.

.

premium; gains

discount; gains

premium; losses

discount; losses

Which of the following bonds has the most interest rate risk?

10-year maturity; 7 percent coupon bond

10-year maturity: 4 percent coupon bond.

8-year maturity; 4 percent coupon bond.

5-year maturity; 7 percent coupon bond

5-year maturity; 4 percent coupon bond.

A.

premium; gains

B.

discount; gains

C.

premium; losses

D.

discount; losses

Which of the following bonds has the most interest rate risk?

A.

10-year maturity; 7 percent coupon bond

B.

10-year maturity: 4 percent coupon bond.

C.

8-year maturity; 4 percent coupon bond.

D.

5-year maturity; 7 percent coupon bond

E.

5-year maturity; 4 percent coupon bond.

Explanation / Answer

Question 1

You don't need to calculate the price of bond, if you know the relationship between bond price, coupon and YTM.

By this relationship,

if YTM < Coupon rate, Bond price is higher than par, i.e., it will trade at premium

if YTM > Coupon rate, Bond price is lower than par, i.e., it will trade at discount

if YTM = Coupon rate, Bond price is equal to par, i.e., it will trade at par value

In our question, the YTM = 4.25% and Coupon rate = 6%. This implies YTM < Coupon rate and hence, bond will trade at PREMIUM.

Now, at maturity, the maturity value of bond would be its face value (or par value), which in this case will be $1000. This means the buying price was at premium to par, but maturity price will be the par value. This implies capital LOSSES.

Hence the answer is option - C. Premium, Losses

Question2

Interest rate risk of a bond is represented by the term 'DURATION'. Higher duration implies higher interest rate risk.  Duration is expressed as a number of years.

2 factors that affect duration of a bond are - coupon rate and time to maturity.

The longer the maturity, the higher the duration, and the greater the interest rate risk.

The higher the coupon rate, the lower the duration, and the lower the interest rate risk.

Now, in our question,

longest maturity time is 10-year - which is bonds in Option A and Option B

lower coupon of these two options is 4% - Option B.

Hence, highest interest rate risk lies with Bond in Option B

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