Sydney purchases a newly issued, two-year government bond with a principal amount of $10,000 and a coupon rate of 6 percent paid annually. One year before the bonds matures (and after receiving the coupon payment for the first year), Sydney sells the bond in the bond market. What price (rounded to the nearest dollar)will Sydney receive for his bond if newly issued one-year government bonds are paying a 5 percent coupon rate?

Question

Quizplus · Accepted Answer

In equilibrium, the previously issued bond must pay the same as the newly issued bond. The previously issued bond pays $10,000 × 1.06 = $10,600 when redeemed in a year, while the newly issued one-year bond pays $10,000 × 1.05 = $10,500. Therefore Sydney's previously issued bond sells at a premium. Since the price of Sydney's bond must allow the purchaser to earn the same 5 percent as on the newly issued bond, the bond price can be computed as: Bond price × 1.05 = $10,600 or Bond price = $10,600/1.05 = $10,095.

Sydney Purchases a Newly Issued, Two-Year Government Bond with a Principal