Consider a corporate bond issue with face value (F) = $1,000, coupon rate (c) =

Question

Consider a corporate bond issue with face value (F) = $1,000, coupon rate (c) = 6%, and exactly 3 years term to maturity (N).   Assume that payments will be paid exactly 1, 2, and 3 years from now.    

Find the value of the bond assuming that the yield to maturity (market interest rate) = 6%

Suppose that you buy the bond in the morning and immediately after the purchase very bad news about the bond issuer hits the market. If the YTM for this bond jumps to 10%, what will happen to the price of the bond?   Suppose that the yield to maturity jump to 10% and is still 10% 1 year later. Find the price of the bond 1 year later (when the remaining term of the bond is 2 years).

Compute the return on investment in the bond assuming that you buy the bond at the value you computed in part a., hold the bond for 1 year, and sell the bond for the price you found in part b.        

Suppose the bond issuer had issued another bond, identical to the first expect that the second pays (cF/2) every 6 months. What can you say about this bond’s price?   

Explanation / Answer

Solution:

The payments made in the question is coupon payments yearly = 6 % * 1,000 = $ 60 per year

Value of Bond = Annual Payments * PVAF(6 %, 3 Years) + Redeemable Value* PVIF(6%, 3 years)

                       = $ 60 *2.6730+ $ 1000* 0.8396 = $ 1,000

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