Lynn Parsons is considering investing in either of two outstanding bonds. The bonds both have $1,000 par values and 11% coupon interest rates and pay annual interest. Bond A has exactly 5 years to maturity, and bond B has 15 years to maturity.
a. Calculate the value of bond A if the required return is (1) 8%, (2) 11%, and (3) 14%.
b. Calculate the value of bond B if the required return is (1) 8%, (2) 11%, and (3) 14%.
c. From your findings in parts a and b, complete the following table, and discuss the relationship between time to maturity and changing required returns.
Required return Value of bond A Value of bond B
8% ? ?
11 ? ?
14 ? ?
d. If Lynn wanted to minimize interest rate risk, which bond should she purchase? Why?
This solution illustrates how the price of a bond varies based upon the prevailing interest rates. It also discusses interest rate risk.