Question

Consider the characteristics of two annual pay bonds from the same issuer with the same priority in the event of default:

Bond A Bond B
Par value $100 $100
Coupons Annual Annual
Maturity 3 yrs 3 yrs
Coupon rate 10% 6%
Yield to maturity 10.80% 10.90%
Price 98.04 88.00

You also observe the following spot interest rates from the current yield curve:
Term (yrs) Spot Rates (zero coupon, %)
1 6 %
2 9
3 11

Neither bond's price is consistent with the spot rates. Using the information in these displays, recommend either Bond A or Bond B for purchase. Justify your choice. Do not round intermediate calculations. Round your answers to the nearest cent.
The non-arbitrage price of Bond A: $
The non-arbitrage price of Bond B: $
-Select-Bond ABond BItem 3 appears to be the better purchase.

Answer 1

To determine the best bond to purchase between Bond A and Bond B, calculate the non-arbitrage prices using the coupon payments and the spot rates for each term. Compare these prices with the market prices to identify the better investment opportunity.

Step-by-step explanation:

To determine the better bond purchase between Bond A and Bond B, we must first calculate the non-arbitrage prices of each bond using the given spot rates. The calculation will take into account the given coupon payments and the final par value repayment, which are discounted by the respective spot rates for each term. For Bond A, it pays an annual coupon of 10%, which means payments of $10 for the first two years and $110 in the final year, which includes the par value repayment. Bond B, with a coupon rate of 6%, will pay $6 annually for the first two years and $106 in the final year. Let's calculate the present value of these payments using the spot rates.

Bond A:Year 1: $10 / (1 + 6%)
Year 2: $10 / (1 + 9%)2
Year 3: $110 / (1 + 11%)3

Bond B:Year 1: $6 / (1 + 6%)
Year 2: $6 / (1 + 9%)2
Year 3: $106 / (1 + 11%)3

Upon calculating these values, we sum them to obtain the present value for both bonds, which determine their non-arbitrage prices. Since both bonds have their prices given, we can compare the calculated non-arbitrage prices to the market prices to see which one offers a better buy opportunity.