Question

8. Croft Inc, bonds have a par value of $1,000. The bonds have a 4% coupon rate and will mature in 10 years. Assume the bond is semi-annual a. Calculate the price if the yield to maturity on the bonds is 7, 8, and 9 percent, respectively. b. Explain the impact on price if the required rate of return decreases. c. How does the relationship between the coupon rate and the yield to maturity determine how a bond's price will compare to it par value? Answer: a. 7% YTM price = $1,071.06 8% YTM price = $1,000.00 9% YTM price = $934.96 b. The price of the bond will increase.

Please explain how this answer was determined using formulas or a financial calculator if applicable. Especially part A. Thanks!

Answer 1

Ans .The answer is based on basic rules of interest of bond and it's valuation in case of any change in interest rate ,maturity and any further issue of bonds.

(A) since the coupen on bond is semi annual the net payment of intrest in a year would be 80 at 4% intrest rate so if in the case of

(1) 7 % yield to maturity ytm is less than the present intrest received the value of bond would be adjusted to reflect the change which in this case would be incresed to 71 dollar approximate taking into consideration 10 year maturity of bond.

(2) Since 8% ytm is similar to 4 % coupon rate of existing bond as intrest is payable semiannually the price of bond will remain same.

(3) 9% ytm is more than the current rate of 4% semi annual payment rate of interest so the par value of bond would be decreased to the adjusted level of 934 in order to keep the bond attractive for investment .

(B) If the rate of of return is reduced for example if a investor is getting a return of 8 % annually at dollar 1000 bond the investment on 1 bond will be 1000 and return would be 80 dollar annually and investor would get dollar 1000 on maturity now of the annual return goes down to 6 % then on investment of same 1000 investor would get 2% less return so it is clear price of bond would increase to nullify the loss of interest.

(C) This is general rule of bond trading and valuation which is being explained here .