Final answer:
When you buy a bond at a premium, you pay more than the bond's par value because the bond offers an interest rate above the prevailing market rates. For instance, if a $1,000 par value bond is expected to pay $1,080 in a year and current market interest rates are 12%, the bond should not cost more than $964 to avoid paying a premium.
Step-by-step explanation:
If you buy a bond at a premium, the par value will be less than the original cost. When purchasing a bond at a premium, this means you are paying more than its par value, typically due to the bond having a higher interest rate than the current market rate. As such, if the interest rates fall after a bond is issued, and the bond's rate is higher, it will sell for more than its face value.
For example, let's say the expected payments from a bond one year from now are $1,080 because in the bond's last year the issuer will make the final interest payment and also repay the original $1,000. If currently, the market interest rates are 12%, an alternative investment of $964 would grow to $1,080 in one year at that rate ($964(1 + 0.12) = $1080). Hence, you would not want to pay more than $964 for the bond, since it would mean buying it at a premium above what could be earned elsewhere at the current interest rate, and the par value of the bond is only $1,000.