4. Bond valuation Aa Aa The process of bond valuation is based on the fundamenta

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4. Bond valuation Aa Aa The process of bond valuation is based on the fundamental concept that the current price of a security can be determined by calculating the present value of the cash flows that the security will generate in the future There is a consistent and predictable relationship between a bond's coupon rate, its par value, a bondholder's required return, and the bond's resulting intrinsic value. Trading at a discount, trading at a premium, and trading at par refer to particular relationships between a bond's intrinsic value and its par value. These result from the relationship between a bond's coupon rate and a bondholder's required rate of return pay, and a bondholder's required return Remember, a bond's coupon rate partially determines the interest-based return that a bond reflects the return that a bondholder to receive from a given investment. The mathematics of bond valuation imply a predictable relationship between the bond's coupon rate, the bondholder's required return, the bond's par value, and its intrinsic value. These relationships can be summarized as follows: . When the bond's coupon rate is equal to the bondholder's required return, the bond's intrinsic value will equal its par value, and the bond will trade at par . When the bond's coupon rate is greater to the bondholder's required return, the bond's intrinsic value will its par value, and the bond will trade at a premium . When the bond's coupon rate is less than the bondholder's required return, the bond's intrinsic value will be less than its par value, and the bond will trade at For example, assume Grace wants to earn a return of 10.50% and is offered the opportunity to purchase a $1,000 par value bond that pays a 8.75% coupon rate (distributed semiannually) with three years remaining to maturity. The following formula can be used to compute the bond's intrinsic value: Intrinsic ValueG tt 4taCt0t6 Complete the following table by identifying the appropriate corresponding variables used in the equation Unknown Variable Name Variable Value $1,000 Semiannual required return Based on this equation and the data, it is less than $1,000 to expect that Grace's potential bond investment is currently exhibiting an intrinsic value

Explanation / Answer

When coupon rate is greater than required return, then bond's intrinsic value will be greater than its par value.

When coupon rate is lower than required return, then bond's intrinsic value will be lower than its par value and the bond will trade at a discount.

A - Semi-annual coupon = 8.75% x 1000 / 2 = 43.75

B - Par-value

C - Semi-annual required rate = 10.5%/2 =5.25%

As the required rate is greater than coupon rate, it is fair to assume that the intrinsic value of the bond is less than its par value of $1,000

A = 8.75% x 1000 / 2 = 43.75, B = 1000, C = 6.75% / 2 = 3.375%

Using the equation above, we get intrinsic value = $1,054 so it is premium bond.

The second statement is correct as mentioned earlier.

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