A bond has a coupon rate of 10%. Interest rate fall to 8%. In which direction the market price of the bond will move, if (a) bonds are callable and (b) bonds are not-callable.
Jag Bhushan Sharma (Faculty in a B-School) (633 Points)
11 August 2011A bond has a coupon rate of 10%. Interest rate fall to 8%. In which direction the market price of the bond will move, if (a) bonds are callable and (b) bonds are not-callable.
vishnupriya
(CA Final)
(1418 Points)
Replied 11 August 2011
Bond's market price always varies inversely to market interest rates. If market interest rates are rising, the prices of outstanding bonds will be falling and vise versa.
The reason for this relationship is that given a fixed coupon associated with a bond, in order to equalize the yield of existing bonds with new bonds, the price of existing bonds will change to adjust for changes in current market interest rates. If current market interest rates rise, then the prices of existing bonds will fall or the prices of existing bonds will increase when current market interest rates fall.
So in the case mentioned by you the market price of the bond will be in rising trend whatever the bond maybe either callable or noncallable.
Jag Bhushan Sharma
(Faculty in a B-School)
(633 Points)
Replied 11 August 2011
You are right pearl that there is an inverse relationship between interest rates and prices of bonds. But in case of callable bonds, if the interest rates fall, the company will definitely like to call bonds and reissue bonds at lower interest rates. So, in case of callable bonds the prices of bonds will come down with decrease in interest rates.https://facebook.com/jbsclasses
vishnupriya
(CA Final)
(1418 Points)
Replied 11 August 2011
well thanks for the correction regarding callable bonds Sir!!
Jag Bhushan Sharma
(Faculty in a B-School)
(633 Points)
Replied 12 August 2011
vishnupriya
(CA Final)
(1418 Points)
Replied 12 August 2011
In my opinion.........
(Maturity value includes premium.)
Now the yield will be (Bondvalue - Present value of facevalue of debentures)
Jag Bhushan Sharma
(Faculty in a B-School)
(633 Points)
Replied 12 August 2011
Pearl, the formula you have provided to calculate the yield to call is absolutely right. Only thing is that yield will be equal to the value of r, which stands for return till calling. Actually r the rate by which we discount all the cash inflows and the sum of all the present values should equal the price paid by the investor at the time of buying. Actually this is an application of IRR Method.
herry1
(exactive)
(27 Points)
Replied 12 August 2011
Hi..............
Jag Bhushan Sharma I have no idea to calculate.Can youm tell me in easy way what i do?
Thanks for sharing.
vishnupriya
(CA Final)
(1418 Points)
Replied 12 August 2011
Thankyou Sharma Sir!! Please share more logical questions in Financial Management with us..
Jag Bhushan Sharma
(Faculty in a B-School)
(633 Points)
Replied 17 August 2011
Dear Herry, I reframe the question so that I could show you calculations.
If a company calls its 8% debentures of face value Rs.100 which were issues at par, at a premium of 10% of the face value at the end of 5th year, how much would be the yield to call for the investors?
As you know the investor will receive Rs.8 every year as interest on Rs.100. After 5 years company will pay to the investor Rs.118 (Principal + Rs.8 interest + Rs.10 as premium). As you know Rs.8 received every year is not equal (because of time value of money), we would like to know the discount rate which will equate the amount paid by the investor for its purchase to the sum of the present values of all the receipts during the 5 year period.
100 = 8/(1.0965) + 8/(1.0965)2 + 8/(1.0965)3 + 8/(1.0965)4 + 118/(1.0965)5
This means the investor has received an annualized return of 9.65% for a period of 5 years. In case of any doubt don’t hesitate to ask anything.
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