Question

Which of the following statements is CORRECT? O 10-year, zero coupon bonds have more reinvestment risk than 10-year, 10 % coupon bonds OA 10-year, 10% coupon bond has less reinvestment risk than a 10-year, 5 % coupon bond (assuming all else equal). The total (rate of) return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year, divided by the bond's price at the beginning of the year O The price of a 20-year, 10 % bond is less sensitive to changes in interest rates than the price of a 5-year, 10% bond. O A$1,000 bond with $100 annual interest payments that has 5 years to maturity and is not expected to default would sell at a discount if interest rates were below 9% and at a premium if interest rates were greater than 11 %.

Answer 1

The correct statement is

The total (rate of) return on a bond during a given year is the sum of the coupon interest payments received during the year and the change in the value of the bond from the beginning to the end of the year, divided by the bond’s price at the beginning of the year.

The total (rate of) return on a bond during a given year = {the coupon interest payments + (Price of the bond at the end of the year - Price of the bond at the beginning of the year)}/ Price of the bond at the beginning of the year

All the other statements are wrong because -

• Reinvestment risk is higher for high coupon paying bonds
• Higher maturity bonds are more sensitive to interest rate changes
• If discount interest rate is more than annual interest payments then bond will sell at discount and if discount interest rate is less than annual interest payments then bond will sell at premium