Final answer:
The price of the corporate bond is determined by calculating the present value of its future cash flows, including semi-annual coupon payments and the principal amount, against the yield composed of the Treasury bond yield and the credit spread.
Step-by-step explanation:
To calculate the price of a corporate bond with a maturity of 2 years, a semi-annual coupon rate of 5.9%, and a AA credit rating, one must first consider the yield to maturity (YTM) on a comparable Treasury bond and the credit spread for AA bonds. We have a Treasury bond YTM of 1.9% with semi-annual compounding and a credit spread of 88 basis points (0.88%). The yield for the corporate bond would then be the sum of these two figures, which is 2.78% (1.9% + 0.88%).
The next step is to calculate the present value of the bond's future cash flows, which include semi-annual coupon payments and the principal amount at maturity. The formula for pricing bonds is as follows:
Bond Price = (∑ (Coupon Payment) / (1 + YTM/2)^(2*t)) + (Face Value / (1 + YTM/2)^(2*T))
Where:
- Coupon Payment = $1,000 * 5.9% / 2 = $29.5 (since coupons are semi-annual)
- YTM = 2.78% / 2 = 1.39% (annual to semi-annual rate)
- T = 2 years
Therefore, the bond price can be calculated by replacing the values into the bond price formula.