The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual

Question

The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1000 at maturity. Bond L has a maturity of 15 years, and Bond S has a maturity of 1 year. (Please show all calculations)

What will be the value of each of these bonds when the going rate of interest is 5%, 8% and 12%? Assume that there is only one more interest payment to be made on
Bond S.

Why does the longer term 15 year bond fluctuate more when interest rates change than does the shorter term bond (1 year)

Explanation / Answer

Bond L will pay $100 for 15 years and $1000 in the 15th year. Bond S will pay $100 for a year and $1000 at the end of first year. To calculate the value of each bond, discount the cash flows at the going rate of interest. Value of Bond L when interest rate equals: 5% = $1518.98 8% = $1171.19 12% = $863.78 Value of Bond S when interest rate equals: 5% = $1047.62 8% = $1018.52 12% = $982.14 The longer term bond is more sensitive to interest rate changes than the shorter term bond because its duration is higher. That is, the longer term bond has cash flows spread over a longer period which will fluctuate when discounted at differing interest rates.

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