Question

PLEASE SHOW WORK

(6p) Suppose there are two bonds, they are exactly the same except one has 10-years to maturity and the other has 25- years. (They have the same face value of $1,000, and same coupon rates). Suppose you expect the FED to further reduce the interest rates by 0.59-50bsp (bsp means basis points where 100bsp-196) Suppose you also want to invest in these bonds. Would you buy them now. given your expectation on the FED's decision? Explain your decision in 1-2 sentences.

Answer 1

Given the expectation on the FED's decision, if FED reduces the interest rate by 5% (50 bps), it is preferred to opt bond investment with 25 years to maturity. Reason: Bond investment is a type of investment that investors make in capital markets with the objective of receiving periodic coupon payments during life of the bonds and principal amount at maturity, either at par or at discount or at premium, as spelt out on the bond instrument by the issuer of such bonds. Bond investment is considered as long-term bond if its maturity period exceeds one year from the date of purchasing the same; otherwise, it is considered as short- term bond by the investors. Bond's price is fixed by calculating present worth of future cash flows such as coupons and face value at maturity using bond's yield to maturity as the discount rate. Time value of money will decrease when time increases due to decrease in worth of the same when discounted at applicable discount rate. Therefore, when interest rate changes, (interest % is nothing but bond's yield to maturity) there will be more change in long-tem bond's price than short-term bond's price. There is an inverse relationship between FED's interest rate and bond prices. That is, if interest rate decreases, bond price will increase; if interest rate increases, bond price will decrease. As an investor, when FED reduces interest rate, it will be preferred to invest in those bonds that will yield more returns in terms of more upward change in bond price due to change in interest rate. So, when FED reduces interest rate by 5%, the bond with 25 years to maturity will yield more returns than a bond with 10 years to maturity.