Question

3. (10 marks) An ABC bond has 20 years till maturity, a coupon rate of 10% and sells @ 104,4062. a) What is the yield to maturity (YTM)? (4 marks) b) If this bond has a YTM of 10%, what should its fair price be? (3 marks) c) If after 1 year of holding this bond you find out that the yield drops to 5%. Is it a good or a bad sign for you? Why? (3 marks)

FV = 100

Answer 1

3a) Given: face value = 100

Present value = 104.4062

Time = 20 years

Coupon rate = 10%

Coupon = 10% of face value

= 10% * 100 = 10

Using financial calculator

Inputs: N =20

Fv = 100

Pv = 104.4062

Pmt = 10

I/y (ytm) =compute

We get I/Y or ytm = 9.5%

3b) If ytm is equal to 10% , which is same as that of the coupon rate then the present value of bond will be be equal to its face value. It is shown below

Given : Ytm = 10%

Face value = 100

Time = 20 years

Coupon = 10

Using financial calculator,

Inputs : i/y =10%

Pmt =10

Fv = 100

N = 20

Pv = compute

We get, PV or fair value = 100

3c) if the yield drops to 5% then the investor will not only earn yield but also benefit from capital appreciation because there is an inverse relationship between price of the bond and yield. It is a good sign as we hold the bond and the price goes up. So if we sell the bond we get a high price .