423.8
8.Consider a 4-year, $1000 par 8% coupon bond with annual coupon payments.
a. Write down the cash flows for this bond. (5)
0 1 2 3 4 80 80 80 1080
b.If the current yield curve shows the rates listed in the table, will this bond be priced at par, a discount, or at a premium? (5)
Maturity
Interest Rate
1 yr
5.0%
2 yrs
6.0%
3 yrs
6.7%
4 yrs
7.2%
Premium
c.Explain why it makes economic sense that the bond should be priced as you said in (b). (7)
All of the current spot rates are less than 8%, meaning other investments are currently offering less than 8% for investments up to 4 years. In order to be priced at par, this bond would have to be offering something between 5 and 7.2%. Since this bond is offering 8%, it is attractive relative to those other investments and its price must rise.