QUESTION 4 Which of the following statements are true? I. The price of discount

Question

QUESTION 4 Which of the following statements are true? I. The price of discount bonds will increase as the bond approaches maturity generating capital gains. Il. The price of discount bonds will dearease as the bond approaches maturity generating capital losses IlI. The price of premium bonds will increase as the bond approaches maturity generating capital gains IV. The price of premium bonds will decrease as the bond approaches maturity generating capital losses. A. I are true Bonly l is true C. I and ilare true Os E.lad are true

Explanation / Answer

Option: A. I and IV are true

Correct options evaluation:

All bonds are pulled to the par level at maturity. Whatever be the bond price before maturity the prices will move towards the principal value. Hence, discounted bond move towards par value and premium bond also moves towards par value. So, discounted value appreciates with passage of time and premium value depreciates with passage of time.

I.     

The price of discount bonds will increase as bond approaches maturity generating capital gains. We can break down this in numeric understanding. Suppose a discounted bond of par value $ 100 is issued $ 90 which will mature after 2 years. Yield for two years be 5.41% annually. After a year bond will be valued at ~ $ 94.86 (= 90 x (1+5.41%) ) and at the end of the 2nd year bond will be valued at $ 100 (=$ 94.86 x (1+5.41%)). Hence, we can observe the rise in price of bond for a discounted bond in year 1 from $ 90 to $ 94.86 and in year 2 from $ 94.86 to $ 100. This proves two points that investor see rise in bond price and investor has to register capital gains if his time of entry is before maturity (price increase with increase in time).

IV.

The Price of premium bonds will decrease as bond approaches maturity generating capital losses. We                can break down this in numeric understanding too. Suppose a bond at par value $ 100 issued at premium $ 109 and matures after two years. The yield be 4.44% for next two years. After a year bond will be become $ 104.44 (=109/1.044) and after end of 2nd year bond will be at $ 100 (104.44/1.044). We can observe that price of bond is decreasing from year1 to year 2 and proves our point of premium bond decreases as bond approaches maturity. Hence, it will result in capital losses for investors who have entered any time before its maturity date.

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