Question

Absalom motors’s 14% coupon rate, semiannual payment, $1,000 par value bonds that mature in 30 years are callable 5 years from now at a price of $1,050. the bonds sell at a price of $1,353.54, and the yield curve is flat. assuming that interest rates in the economy are expected to remain at their current level, what is the best estimate of the nominal interest rate on new bonds?

Answer 1

The nominal interest rate on new bonds can be approximated by the current market yield of existing bonds, given that a bond with a 14% coupon is selling above par value. This suggests current market interest rates are below 14%, but an exact nominal interest rate would require calculation of the yield to maturity on the bond in question.

Step-by-step explanation:

The question is concerning the nominal interest rate on new bonds given the current price of an existing bond with a known coupon rate and future callable price. To estimate the nominal interest rate on new bonds, considering that interest rates are expected to remain at their current level, we can look at the current price at which an existing bond is trading. The fact that Absalom Motors's bond with a 14% coupon rate is currently selling for $1,353.54 suggests that the yield or return required by the market is lower than the coupon rate, indicating that the current market interest rates are below 14%.

We also know that bonds previously issued at higher interest rates will sell for more than face value when market interest rates fall, as they become more attractive to investors. However, to accurately determine the nominal interest rate for new bonds, we would need to perform a calculation that includes the present value of the bond's expected future cash flows discounted at the bond's yield to maturity.