Teresa bought a corporate bond with the time to maturity of 10 years, yield to m

Question

Teresa bought a corporate bond with the time to maturity of 10 years, yield to maturity of 8%, and face value of $1,000. It pays semiannual coupons and the coupon rate of 8%.

(a)   Was the bond sold at a premium, discount, or par? Calculate and explain in words all calculations.

(b)   Carl, a friend of Teresa, bought a different financial security (not a bond), which pays equal annual payments for 10 years at the end of each year. The discount rate for this security is 15%. If Carl paid the same amount for this security as Teresa paid for her bond, what annual payment should Carl expect? Calculate and explain in words all calculations.

Explanation / Answer

Bonds can be sold at various prices depending on the market interest rates at the time. They can be sold at discount (below market) premiums (above market) or at "par" (face value). The value of the bond is determined by fluctuations in the interest rates and will provide a guide as to the payouts that the bond will give to you or how much "cash flow" it is expected to provide. If a bond's value diminishes, it must be discounted to the buyer. In other words, if its interest rate was 10 percent 5 years ago but the market rate is only 7 percent now, the bond must be discounted to account for less payout amounts over the life of the bond. You can calculate the discount rates of your bond if you know your basic bond values and some algebra.

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