You are considering the purchase of two $1,000 bonds, both issued by Tranig Corp

Question

You are considering the purchase of two $1,000 bonds, both issued by Tranig Corp. Your expectation is that interest rates will drop and you want to buy the bond which provides the maximum capital gains potential. The first Tranig bond has a coupon rate of 6 percent with five years to maturity, while the second has a coupon rate of 9 percent and comes due six years from now. If market rates of interest are 8 percent for both bonds, which bond has the best price potential? (Use duration to answer the question)

Explanation / Answer

Computation of Duration of Bond with 5Years maturity & 6% Coupon rate

Duration of Bond with 5years maturity is 4.4408

Computation of Duration of Bond with 6Years maturity & 9% Coupon rate

Duration of Bond with 6 year maturity& 9% coupon rate is 4.9168

Duration of Bond with 5years maturity& 6% coupon rate is 4.4408

Bond with best price potential:

Duration of Bond with 6year maturity & 9% coupon rate is more than Duration of Bond with 5years maturity& 6% coupon rate,so bond with high duration is best price potential.

Year Cash Flow($) PVF@8% PV of Cash Flow weight=PV of Annual cashflow/Total PV of cash flow Duration=Weights *Year 1 60(1000*6%) 0.926 55.56 =55.56/920.58=0.060 0.060 2 60 0.857 51.42 =51.42/920.58=0.0559 0.1118 3 60 0.794 47.64 =47.64/920.58=0.0518 0.1554 4 60 0.735 44.10 44.1/920.58=0.0479 0.1916 5 60 0.681 40.86 =40.86/920.58=0.0444 0.222 5 1000 0.681 681 =681/920.58=0.74 3.7 920.58 4.4408

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