Question

Define coupon and market/effective interest rates as they determine bond pricing at par, premium, or discount values.

Answer 1

ANSWER

WHEN THE BONDS ARE ISSUED, THERE ARE TWO TYPES OF RATES ASSOCIATED WITH ISSUE OF BONDS:

1. COUPON RATE - RATE AT WHICH INTEREST IS BEING PAID TO THE INVESTOR, WHICH IS SPECIFIE DIN THE BOND INDENTURE / CONTRACT.

2. EFFECTIVE INTEREST RATE - RATE WHICH IS ACTUALLY EARNED BY THE BONDHOLDER AND IS RETURN EARNED ON COMPARABLE CONTRACTS AT TIME WHEN THE BONDS ARE ISSUED.

CASE 1  WHEN COUPON RATE = EFFECTIVE RATE - BONDS WILL BE ISSUED @ PAR

CASE 2  WHEN COUPON RATE > EFFECTIVE RATE - BONDS WILL BE ISSUED @ PREMIUM

CASE 3  WHEN COUPON RATE < EFFECTIVE RATE - BONDS WILL BE ISSUED @ DISCOUNT