You have been considering a zero-coupon bond, which pays no interest but will pa

Question

You have been considering a zero-coupon bond, which pays no interest but will pay a principal of $1,000 at the end of five years. The price of the bond is now $712.99, and its required rate of return is 7.0%. This morning’s news contained a surprising development. The government announced that the rate of inflation appears to be 5.5% instead of the 4% that most people had been expecting. (Suppose most people had thought the real rate of interest was 3%.) What would be the price of the bond, once the market began to absorb this new information about inflation?

Explanation / Answer

New nominal rate (R ) = real rate + inflation rate

                                           = 3%+5.5%

                                           = 8.50%

The price of zero coupon bond would be:

PV= FV/ (1+r)^n

     = 1000/(1+0.085)^5

     =1000/1.503657

     = 665.05

Therefore, new price of the bond would be 665.05.

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.