Final answer:
This question is about calculating the fair price of coupon and zero coupon bonds issued by Telstra, given the required yield-to-maturity rates of 7% for coupon bonds and 5% for zero coupon bonds, while considering interest rate impacts on bond pricing.
Step-by-step explanation:
Zero Coupon and Coupon Bonds Valuation
The question involves an investment manager allocating capital to purchase debt securities, specifically zero coupon bonds and coupon bonds issued by Telstra. With $5 million in capital, $3 million is designated for zero coupon bonds and $2 million for coupon bonds. The bonds have a 5-year term with a face value of $1,000,000. For coupon bonds, the manager requires a yield-to-maturity (YTM) of 7% per annum and for zero coupon bonds, a YTM of 5% per annum.
Bonds are investment instruments that typically pay periodic interest, known as coupons, and return the principal, also known as the face value, at maturity. When bonds are issued, they can be sold at par (face value), a premium (above face value), or a discount (below face value), depending on the prevailing interest rates relative to the coupon rate of the bond. The price of existing bonds inversely correlates with interest rate movements.
Zero coupon bonds, unlike traditional bonds, do not make periodic interest payments. Instead, they are sold at a significant discount to face value. The investor's return comes from the difference between the purchase price and the value at maturity. The coupon bond pays a semi-annual coupon, which in the example provided by Telstra is 6% per annum. The investment manager must calculate the present value of these payments, plus the return of face value at maturity, to determine the fair price of the bond, given the required yields.