Question

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71. An open-end bond mutual fund is holding a three-year, $1 million face value 5 percent annual coupon bond selling at par. What is the impact on the total asset value of the fund of a 1 percent decrease in interest rates? A. A decrease of $10,000.1 B. An increase of $10,000.1 C. A decrease of $26,730.), D. An increase of $27,751.1 E. The answer depends upon the number of mutual funds shares outstanding.

Answer 1

Currently bonds are priced at par. It means, coupon rate = Required rate of return = 5%

A 1% decrease in interest rate means ........ Required rate of return " r " = 5% - 1% = 4%

Price of the bond = Coupon * [ 1 - (1+r)^-n ] / r + Face value * ( 1 + r)^-n

Coupon = 1000,000 * 5% = 50,000. ........... Note: Even if required return decrease, coupon remains fixed at 5%

r = 0.04

n = 3 Years

= 50000 * [ 1 - (1.04)^-3 ] / 0.04 + 1000,000 * (1.04)^-3

= 138754.55 + 888996.36

= 1027751

Thus, increase in bond price (or) fund assets = 1027751 - 1000,000 = 27,751