3 Determine without the use of a calculator if the following

3. Determine without the use of a calculator if the following bonds are trading at a premium, at a discount, or at face value: Starting date 2012.

      a. A 5% bond maturing in 2015 when current interest rates are 6%:               _______________

      b. A 4% bond paying monthly until 2042 when current interest rates are 2%: _______________

      d. What general observation can you make about this?

Solution

A. This will be trading at DISCOUNT. Current market rates are higher than the coupon rate on bond. This means when market is providing higher interest rates, this provides lower, which reduced the demand for this bond. Lower demand implies lower price and hence it trades at diacount.

B. This will be trading at PREMIUM. Market interest rates here are lower than the interest paid by bond. This implies there will be higher demand for this bond. Higher demand means higher price and hence a premium to par value.

D. We can use the above options to formulate our general observations around market interest rates and interest rate on bond or coupon rate. These observations are,

If market rate > coupon rate, bond will trade at discount.

If market rate < coupon rate, bond will trade at premium.

If market rate = coupon rate, bond will trade at par (as demand and supply will be in equilibrium)