ECO 473 – Money & Banking

Dr. D. Foster – Spring 2016

Bond Pricing Exercise

On February 24, 2012, Koala, Inc. issued a 10 year bond (with a typical $1000 face value) that had an annual coupon value of $55.

  • Initially, the bond was sold for the premium price of $1,025.
  • On February 24, 2016, this bond was selling for only $955.
  • The market rate of interest for a riskless corporate bond, of this maturity, was 4.5% on February 24, 2012, which reflects market expectations about future rates of inflation.
  • The market rate of interest for a riskless corporate bond, of this maturity, was 4.0% on February 24, 2016, which reflects market expectations about future rates of inflation.

1. What was the nominal and current yield on this bond on February 24, 2012?

2. What was the nominal and current yield on this bond on February 24, 2016?

3. What was the yield to maturity for this bond on Feb. 24, 2012? On Feb. 24, 2016?

4. What happened to the risk premium for this bond from Feb. 24, 2012 to Feb. 24, 2016?

Briefly, explain why this change may have occurred. [There are a million and one possibilities here, so just be speculative, but reasonable.]

5. Suppose that the market becomes even more certain that future rates of inflation will fall, and the market rate of interest for a riskless corporate bond, of this maturity, falls from 4.0% to 2.5% (i.e., today in 2016). If there is no further change in the risk premium expected for this Koala, Inc. bond, what will its selling price be?

What will be the discounted present value of the income stream of this bond?

2017 / 2018 / 2019 / 2020 / 2021 / 2022
Income:
PV:

What do you note about the sum of the present value of these yearly incomes?