Construct some simple examples to ullustrate your answers to the foloowing: a. I

Question

Construct some simple examples to ullustrate your answers to the foloowing:

a. If interest rates rise, do bond prices rise or fall?

b. If the bond yield is greater than the coupon, is the price of the bond greater or less than 100?

c. If the price of a bond exceeds 100, is the yield greater or less than the coupon?

d. Do high-coupon bonds sell at higher or lower prices than low-coupon bonds?

e. If interest rates change, does the price of high-coupon bonds change proportionately more than that of low-coupon bonds?

Explanation / Answer

Answer

A) If interest rate rise bond prices fall becasue expectation of investor rises, which results in discounting of cashflow from investment at higher rate. Following is an example of bond with 2 years of maturity period

We can clearly see that when interest rates rise price of bond fall due to higher rate of discounting

Answer b:

If bond yield is greater than coupon than price of bond is less than 100 becasue expecation of investor is more than coupon payment, which results in higher rate discounting.

In following example bond coupon rate = 4% and yield is 5%

Answer C:

If the price of bond exceeds 100 the yield of bond is less than coupon rate

In following example bond coupon rate = 6% and yield is 5%

Answer d: Higher coupon bonds sell at higher price than lower prices bond because they offer higher coupon payment

Answer e:

Yes, due to higher risk involved in high coupon bonds, it's price changes more than that of low coupon bonds

Due to change in interest rate high coupon bonds will be discounted at higher rate than lower coupon bonds because of risk involved in high coupon bonds, following is an example of this

Cashflow from bond =(A) discount factor @ 5% =(B) Present value of cashflow from bond = (C) = (A xB) If interest rate rises discount factor @ 6% =(D) Present value of cashflow from bond = (E) = (A xD) 1 6 0.9524 $5.71 0.9434 $5.66 2 6 0.9070 $5.44 0.8900 $5.34 2 100 0.907 $90.70 0.89 $89.00 Total price of bond $101.86 Total price of bond $100.00

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