5. Interest Rate Risk Collapse . Both Bonds A and B are priced at par since thei

Question

5. Interest Rate Risk Collapse . Both Bonds A and B are priced at par since their YTMs are the same as their coupon rate of 7%. What happens to their prices if interest rate in the market rises by 2%? What if the interest rate falls by 2%? Compute the prices in $ and also the percentage change.

Bond A: Bond B: Coupon rate 7% Coupon rate 7% Settlement date 1/1/2000 Settlement date 1/1/2000 Maturity date 1/1/2003 Maturity date 1/1/2020 Redemption (% of par) 100 Redemption (% of par) 100 # of coupons per year 2 # of coupons per year 2 YTM 7%

Explanation / Answer

Bond A

What happens to their prices if interest rate in the market rises by 2%?

YTM=9%/2

PMT= 7%/2*100,FV=100,N=6(3years*2) Semi annual payment

FV=$94.84

What if the interest rate falls by 2%

YTM=5%/2

PMT= 7%/2*100,FV=100,N=6(3years*2) Semi annual payment

FV=$105.51

BOND B

What happens to their prices if interest rate in the market rises by 2%?

YTM=9%/2

PMT= 7%/2*100=3.5 ,FV=100,N=40(20years*2) Semi annual payment

FV=$81.60

What if the interest rate falls by 2%

YTM=5%/2

PMT= 7%/2*100,FV=100,N=40(20years*2) Semi annual payment

FV=$125.10

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