To borrow money from the public, firms sell bonds. A bond is just a piece of pap

Question

To borrow money from the public, firms sell bonds. A bond is just a piece of paper that obligates the firm to pay the holder of the piece of paper a fixed sum of money in each of a fixed number of periods. [(A)]* What is the maximum amount you would pay today for a bond that promised to pay you $5 (the coupon) at the end of each of the next three years, and $105 after four years (coupon + principal), assuming that the interest rate is 5 percent? Assuming that the interest rate is 10 percent? Assuming that the interest rate is 15 percent? [(B)]* If this bond is sold at auction, and if the interest rate is 10 percent, what is your prediction with respect to its price? Explain. What sort of relationship would you expect to see between the price of bonds and the interest rate?

Explanation / Answer

a) use financial caculator and put

N = 4 , I = 5 , PMT(coupon payment) = 5 , FV = 100

So PV = 100 ............because interest rate = coupon payment

when interest rate is 10 %

N = 4 , I = 10 , PMT(coupon payment) = 5 , FV = 100

So PV = 84.15

when interest rate is 15 %

N = 4 , I = 15 , PMT(coupon payment) = 5 , FV = 100

So PV = 71.45

B) If the bond is sold at auction it will be sold at the predicted value of 84.15.

Price of bond and interest rate are inversly related.We can see from our calculation as interest rate increases price of bond decreases.

I = 5% then p = 100, I = 10% then p = 84.15, I = 15% then p = 71.45 ( I (interest rate is increasing and price is decreasing

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