On April 20, 2008 your wealthy aunt will give you a bond with a par value (or a maturity value) of $10,000. Your aunt purchased the bond in 2003, and it matures on April 20, 2009. The bond pays a coupon rate of 8 percent. When it arrives, the bond will have one remaining coupon.
a. If the current relevant rate of interest is 6 percent for the type of bond your aunt is giving you, what will the market value of the bond be on the day you receive it? Why?
b. Given the prospect of new wealth, you decide to check the business section of the newspaper. It suggests that the Bank of Canada soon will reduce interest rates in Canada by one half of one percentage point. If the relevant interest rate for the bond you will receive drops by one half of one percentage point, what will be its market value on the day you receive it? Why?
c. You read further in the business section and discover that the company that issued the bond in 2003 used the $10,000 it received to issue subprime mortgages in the U.S. In other words, the company used the funds it received by issuing bonds to give mortgages to homebuyers who had very poor credit ratings. Participants in the bond market now fear that defaults on mortgages have greatly increased the risk that the original issuer will not be able to pay the par value of the bonds when they mature. As a result, a large risk premium has raised the market rate of interest on your type of bond to 20 percent. What will its value be on the day you receive it?
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