Final answer:
The question is about the effect of current interest rates on the valuation of treasury securities and bonds. If market interest rates rise, existing bonds with lower rates become less valuable, and you would expect to pay less for such a bond. The present value calculation is needed to determine the fair price to pay based on current market rates.
Step-by-step explanation:
The student's question pertains to treasury securities and their interest rates. Specifically, the question involves the concept of interest rate changes over time and their impact on bond valuation, which is a fundamental topic in finance and investment disciplines, commonly discussed at the college level within business courses. When considering the change in interest rates, as exemplified by the local water company bond described, it's crucial to understand how this affects the bond's current market value.
Let's take the scenario provided: a local water company issued a $10,000 ten-year bond with a 6% interest rate. If you are considering buying this bond when there is only one year left to maturity, but the current market interest rate for similar bonds has increased to 9%, you would expect to pay less than the face value ($10,000) for the bond. This is because the bond's fixed interest payments are now less attractive compared to the new bonds issued at the higher current rate of 9%.
To calculate what you would be willing to pay for the bond, you would need to calculate the present value of the bond's future cash flows (the final year's interest payment and the principal repayment) discounted at the current market interest rate of 9%. The exact amount one would be willing to pay can be found using the present value formula for each of the cash flows and summing them up.