15 - current market price (which does not always equal its...

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A firm issues a bond at par value. Shortly thereafter, interest rates fall. If you calculated the coupon rate, coupon yield, and yield to maturity for this bond after the decline in interest rates, which of the three values would be highest and which would be lowest? Explain. A bond is a promissory note issued by a business or a governmental unit. Though bonds come in many varieties, most bonds share certain basic characteristics. First, a bond promises to pay investors a fixed amount of interest, called the bond’s coupon. Borrowers usually make coupon payments semiannually (every six months). Second, bonds typically have a limited life, or maturity. When the bond matures, the borrower repays investors a lump sum known as the bond’s face value, often $1,000. Third, a bond’s coupon rate is derived by dividing the bond’s annual coupon payment by its par value. Forth, a bond’s coupon yield is obtained by dividing the bond’s coupon by its
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Unformatted text preview: current market price (which does not always equal its par value). To illustrate, suppose that a firm issues a bond with a $1,000 par value and promises to pay investors $35 every six months over the life of the bond. The bond’s coupon is $70 per year, and its coupon rate is 7 percent ($70/$1,000). If the current market value of this bond is $980, then its coupon yield is 7.14 percent ($70/$980). When interest rates raise, the prices of outstanding bonds fall; when rates fall, prices rise. This does not affect the coupon rate, but it will lower the coupon yield and the yield to maturity. Because the bond now sells at a premium, there is a built-in capital loss for the investor who paid par value and holds the bond to maturity. Compensating for this loss is the fact that the bond’s coupon yield will be greater than the yield to maturity. So in order we have: Coupon rate > coupon yield > YTM....
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This note was uploaded on 10/15/2011 for the course FIN 550 taught by Professor Smith during the Spring '11 term at Berklee.

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