For example, assume Amelia wants to earn a return of 15.75% and is offered the o

Question

For example, assume Amelia wants to earn a return of 15.75% and is offered the opportunity to purchase a $1,000 par value bond that pays a 13.50% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value: ic Value - (1+C)I 1+C(1+C)1+C 1+C)5+1+C(1+ Complete the following table by identifying the appropriate corresponding variables used in the equation Unknown Variable Name Bond's semiannual coupon payment Bond's par value Semiannual required return Variable Value $67.50 $1,000 7.8750% Based on this equation and the data, it is greater than $1,000 unreasonable to expect that Amelia's potential bond investment is currently exhibiting an intrinsic value Now, consider the situation in which Amelia wants to earn a return of 17%, but the bond being considered for purchase offers a coupon rate of 13.50%. Again, assume that the bond pays semiannual interest payments and has three years to maturity. If you round the bond's intrinsic value to the nearest whole dollar, then its intrinsic value of bond is (rounded to the nearest whole dollar) is its par value, so that the Given your computation and conclusions, which of the following statements is true? O When the coupon rate is greater than Amelia's required return, the bond should trade at a premium O When the coupon rate is greater than Amelia's required return, the bond's intrinsic value will be less than its par value O When the coupon rate is greater than Amelia's required return, the bond should trade at a discount. O A bond should trade at a par when the coupon rate is greater than Amelia's required return

Explanation / Answer

Par value=1000
Coupon=13.5%*1000/2=67.5
Semi-annual required return=15.75%/2=7.875%

As yield is more than coupon, the bond will sell at discount and hence price will be less than 1000. So it is unreasonable to expect intrinsic value of more than 1000

Intrinisc Value=67.5/1.085+67.5/1.085^2+67.5/1.085^3+67.5/1.085^4+67.5/1.085^5+1067.5/1.085^6=920.3122

less than par value so that the bond is selling at discount

When the coupon rate is greater than AMelia's required return, the bond should trade at a premium

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