ABC Inc.issued at par value a 15-year 6% semiannual coupon bond with a par value of $1,000.At the end of 2 years the market interest increases to 7%.One year later,the market interest is 8%.If an investor purchases the bond at the end of year 2 and sold it 1 year later,how much is the capital gain or loss?

Question

Quizplus · Accepted Answer

The bond's price decreases when the market interest rate increases. Initially, the bond was issued at par value ($1,000) because the coupon rate matched the market rate. After 2 years, when the market interest rate increases to 7%, the bond's price drops below its par value because its fixed coupon payments are less attractive compared to new bonds issued at the higher current interest rate. One year later, when the market interest rate increases further to 8%, the bond's price decreases even more. The capital loss is calculated by comparing the purchase price of the bond at the end of year 2 (when the market rate was 7%) to its selling price one year later (when the market rate was 8%). The correct calculation, based on the present value of the remaining coupon payments and the maturity value discounted at the new market rates, results in a capital loss of $68.02.

ABC IncIssued at Par Value a 15-Year 6% Semiannual Coupon Bond