Final answer:
The price of a bond can be calculated by discounting its future cash flows at the market interest rate. If the market interest rate is the same as the bond's coupon rate, the price will be at par value.
Step-by-step explanation:
To calculate the present value of a bond, one must discount the future cash flows of the bond (interest and principal repayments) to their present value using the market interest rate as the discount rate. Applying this method to the provided example, a two-year bond issued for $3,000 with a coupon rate of 8% will pay $240 in interest annually. If the market discount rate matches the coupon rate at 8%, the present value of the bond's cash flows would equal its face value since the expected return matches the market requirement.
However, if the market interest rate increases to 11%, the bond's price will decrease as the present value of future cash flows will be lower due to a higher discount rate being applied. Using the formula PV = C / (1+r)n where C is the cash flow, r is the discount rate, and n is the number of periods, we can calculate the present value of each cash flow and sum them to determine the bond's current price. Following this method, we find that the present value of the bond is lower at an 11% discount rate compared to an 8% rate.