Question

4. Bond valuation The process of bond valuation is based on the fundamental concept that the current price of a security can be determined by calculating the present value of the cash flows that the security will generate in the future. There is a consistent and predictable relationship between a bond's coupon rate, its par value, a bondholder's required return, and the bond's resulting intrinsic value. Trading at a discount, trading at a premium, and trading at par refer to particular relationships between a bond's intrinsic value and its par value. This also results from the relationship between a bond's coupon rate and a bondholder's required rate of return. pay, and a bondholder's required return Remember, a bond's coupon rate partially determines the interest-based return that a bond reflects the return that a bondholder to receive from a given investment. The mathematics of bond valuation imply a predictable relationship between the bond's coupon rate, the bondholder's required return, the bond's par value, and its intrinsic value. These relationships can be summarized as follows: . When the bond's coupon rate is equal to the bondholder's required return, the bond's intrinsic value will equal its par value, and the bond will trade at par. . When the bond's coupon rate is greater than the bondholder's required return, the bond's intrinsic value will its par value, and the bond will trade at a premium. • When the bond's coupon rate is less than the bondholder's required return, the bond's intrinsic value will be less than its par value, and the bond will trade at For example, assume Jackson wants to earn a return of 7.00% and is offered the opportunity to purchase a $1,000 par value bond that pays a 7.00% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value:

Answer 1

1.
Will or Must

2.
Expect

3.
More or Above

4.
Discount

5.
A is Semi annual coupon=1000*7%/2=35
B is Par or Face Value=1000
C is Semi annual required return=7%/2=3.5%

6.
Reasonable

7.
=1000*7%/10%*(1-1/1.05^6)+1000/1.05^6
=923.86

8.
Less than

9.
Discount

10.
When the coupon rate is less than Jackson's required return, the bond should trade at a discount