Lady Products, Inc. just issued 10-year, 8% coupon bonds at par. Outstanding bonds of Limbaugh Corp. Lady's closest competitor, have a maturity of 10 years and are viewed by investors as being of
About the same risk as the Lady bonds, but carry a 5% coupon. Assume market interest rates rise by
ﬁve percentage points. The value of the ______ bonds will fall by $_____ more than the bonds of
Their competitor. (Assume all bonds pay interest annually.)

Question

Quizplus · Accepted Answer

The difference between Lady's and Limbaugh's bonds is the coupon rate. Lady's bonds have an 8% coupon rate while Limbaugh's bonds only have a 5% coupon rate. Therefore, when market interest rates rise by 5 percentage points, Lady's bonds will be affected more than Limbaugh's bonds because investors will demand a higher yield (and therefore, a lower price) from Lady's bonds to compensate for the higher coupon rate. The formula to calculate the difference in value is:

Difference in value = (coupon rate of Lady's bonds - coupon rate of Limbaugh's bonds) x (change in market interest rate) x (face value of bonds) / (1 + market interest rate) ^ n

Plugging in the numbers, we get:

Difference in value = (0.08 - 0.05) x 0.05 x 1000 / (1 + 0.05) ^ 10 = $35.92

Therefore, the answer is B, Lady will fall by $35.92 more than Limbaugh.