Which of the following is true? explain why. 1. Bonds C and Z both have a $1,000

Question

Which of the following is true? explain why.

1. Bonds C and Z both have a $1,000 par value and 10 years to maturity. They have the same default risk, and they both have a yield of 8%. If Bond C has a 15% annual coupon and Bond Z a zero coupon, then Bond Z will be exposed to more interest rate risk, which is defined as the percentage loss of value in response to a given increase in the going interest rate.

2. The interest rate paid by the state of Florida on its debt would be lower, other things held constant, if interest on the debt were not exempt from federal income taxes.

3. Given the conditions in the first statement, we can be sure that the price of Bond Z would be greater than that of Bond C

Explanation / Answer

1 is true because a coupon bond is less exposed to changes in interest rates because some of the change in rates is cushioned by the coupon payments. When we derive a value of bond we derive it by discounting cash flows. A coupon bond has cash flow in near future as well as far future so discounting will be less on nearby coupons so less effect of change in interest rates. Zero coupon on the other hand will be discounted for only farthest cash flow hence more susceptible to change in rates.

2 is not true because if it is not exempt from federal taxes then the payment rate has to be higher to compnesate for taxes

3 is wrong because vond Z which is a zero coupon will always be less than $1000 before maturity and Bond C has a coupon rate more than YTM hence it will be worth more than $1000

Related Questions

Navigate

• Browse (All)
• Browse W
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.