Discuss how to calculate the new bond price after the interest rate change.

Question:

Discuss how to calculate the new bond price after the interest rate change.

Bond Valuation:

Bond valuation entails discounting anticipated cash flows to the present, using an appropriate discount rate, also referred to as a yield to maturity. For most bonds, the cash flows consist of periodic coupon payments and a return of principal at maturity. However, some bonds, known as zero-coupon bonds, do not pay coupons. For these bonds, a single payment occurs at the end of the term.

This problem is best solved via an example.

We can compute a bond's price using a financial calculator, such as a Texas Instruments BAII Plus Professional. Let us do so, using the following hypothetical terms:

Par Value = $1,000,00 Term = 10 years Coupon (paid annually) = 5.0% Current Yield-to-Maturity (YTM) = 5.0% Input the following values into the calculator: I/Y = 5.0 FV =$1,000.00

PMT = $50.00 N = 10 Compute for PV to get a price of$1,000.00. The bond is trading at its par value.

Now, let's assumed interest rates (YTM) rise by 1.0% across the term structure.

Input the following values into the calculator:

I/Y = 6.0

FV = $1,000.00 PMT =$50.00

N = 10

Compute for PV to get a price of \$926.40. The value of the bond has declined, which is to be expected, given the inverse relationship between bond prices and interest rates.