Question

During your dream's summer internship at an investment bank you are assigned the task of pricing a new corporate bond issue. The discount bonds have a face value of $10,000 and are to mature in 3 years.

Your analysis leads you to conclude that the expected payout on the bonds is $9,350 and that investors require a 1.2% risk premium to hold bonds with similar risk profiles. The current YTM on 3-year Government bonds is 2%.
What is the maximum price you think the bonds can be sold for? (Provide your answer in $ with 2 decimals of accuracy. e.g., $1,234.56) (Hint: The expected return on the bonds should reflect the safe return plus the risk premium)

Answer 1

To calculate the maximum price the bonds can be sold for, we need to consider the expected return on the bonds and the present value of the expected payout. The maximum price is $8,751.47.

Step-by-step explanation:

To calculate the maximum price the bonds can be sold for, we need to consider the expected return on the bonds, which should reflect the safe return plus the risk premium. The safe return can be calculated using the current YTM on 3-year Government bonds, which is 2%. The risk premium is 1.2%. So, the expected return on the bond is 2% + 1.2% = 3.2%.

Next, we calculate the present value of the expected payout on the bonds, which is $9,350, using the formula:

Bond price = Expected payout / (1 + rate of return) ^ number of years

Substituting the values, we get:

Bond price = $9,350 / (1 + 0.032) ^ 3 = $8,751.47

Therefore, the maximum price the bonds can be sold for is $8,751.47.