Question

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2) Describe the normal relationship between bond prices and interest rate. (15 points) a. What is the difference between the required Rate of Return and the Coupon rate? b. List the items need to calculate the Present Value of a Bond C. List the items necessary to calculate the rate of return on a Bond

Answer 1

(2) Price of a bond is the present value of its cash flows, cash flows being the interest payments and principal repayment. Bond prices and interest rates are inversely related. Higher the interest rates, lower the bond prices and lower the interest rates, higher the bond prices.

(a)

The required return is the yield of the bond. It is the return if the bond is purchased and held till maturity.

The coupon rate is fixed and is the periodic interest rate payable on the face value of the bond. The coupon rate will be different from the yield (required return) unless the bond is trading at par. For a bond trading at par, coupon rate and yield will be equal.

(b)

To calculate present value, we require :

• required return (yield)
• years to maturity
• coupon rate
• face value

(c)

To calculate rate of return, we require :

• years to maturity
• coupon rate
• current price of bond
• face value