Valuing Bonds: Discount Bond and Premium Bond - Essay Example

Note: In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receiving credit for your answer.
1. "What does a call provision feature allow bond issuers to do, and why would they do it?" (Cornett, Adair, and Nofsinger, 2012, p. 146).
The call provision feature allows bond issuers to pay off the remaining debt early before the maturity date. The role of the borrower is to make a lump sum payment derived from a formula based on the net present value (NPV) of future coupon payments that will not be paid because of the call. The call provision right is usually exercised at times of low-interest rates and it allows the bondholder to retire what is currently a high-interest debt and reissue it at a lower interest rate. Call provisions limit a bond's potential price appreciation because when interest rates fall, the price of a callable bond will not go any higher than its call price. Thus, the true yield of a callable bond at any given price is usually lower than its yield to maturity.

2. "Provide the definitions of a discount bond and premium bond. Give examples." (Cornett, Adair, and Nofsinger, 2012, p. 146).

A discount bond is a bond issued at a price lower than its par value and is a bond currently trading at less than its par value in the secondary market. An example is a $4,000,000, 9%, 5-year bond with a par value of $1000 issued at $970.

A premium bond is a bond issued at a price higher than its par value and is a bond currently trading at more than its par value in the secondary market. An example is a $4,000,000, 9%, 5-year bond with a par value of $100 issued at $105.

3. "Describe the differences in interest payments and bond prices between a 5 percent coupon bond and a zero coupon bond." (Cornett, Adair, and Nofsinger, 2012, p. 146).

For a 5% bond, interest paid is calculated at the interest rate on the par value of the bond and is paid periodically (annually or semi-annually) while for a zero coupon bond, no periodic interest payments are made. When the bond reaches maturity, its investor receives its par (or face) value.

"Calculate the price of a $1,000 (FV) zero coupon bond that matures in 20 years if the market interest rate is 6.5 percent." (Cornett, Adair, and Nofsinger, 2012, p. 147). Assume semi-annual compounding.

P = M / (1+r)n

P = price, M = maturity value, r = investor's required annual yield, n = number of years until maturity

P= 1000/(1+0.00325)40=                    1000/(1.0.0325)40= 28.33.     

4. "Compute the price of a $1,000 (FV) 4.5 percent coupon bond with 15 years left to maturity and a market interest rate of 6.8 percent." (Cornett, Adair, and Nofsinger, 2012, p. 148). Assume interest payments are paid semi-annually, and solved using semi-annual compounding. Is this a discount or a premium bond?

Maturity value= P(1-r)           where P= par value and r= interest charged on Par value

N=30 (15 years interest compounded semi-annually)

= 1000(1.045) = 1045

The bond is sold in a secondary market @ 6.8%

Price= Maturity value/(1+r)30=          1045/(1.068)30=355.98.

This is a premium bond.

5. "A 6.85 percent coupon bond with 26 years left to maturity is offered for sale at $1,035.25. What yield to maturity [interest rate] is the bond offering? Assume interest payments are paid semi-annually, and solved using semi-annual compounding. (Cornett, Adair, and Nofsinger, 2012, p. 148).

Future value= P(1+r)n where P=1035.25  r= 3.425 n=52

                        =1035.25(1.03425)52= 5964.48

P          =          1035.25,          n = 52, M= 5964.48

P= M/(1+r)n                           1035.25= 5964.48/(1+r)52

(1+r) 52 = 0.1736         52log (1+r) = log 0.1736

52 log (1+r)= -0.7605            

Log (1+r)=      -0.0146

R=9.6%