Answer: The value of Bond S at 6%, 8%, and 12% interest rates would be $1,106.00, $1,089.00, and $1,063.00 respectively. The value of Bond L at 6%, 8%, and 12% interest rates would be $1,321.97, $1,178.64, and $1,000.00 respectively.
Explanation: The value of a bond is calculated by discounting the expected cash flows from the bond. The cash flows include the coupon payments and the principal repayment. The discount rate used is the yield to maturity (YTM) of the bond. The YTM is the rate that makes the present value of all future cash flows equal to the current market price of the bond.
The value of a bond is inversely related to changes in interest rates. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This relationship between bond prices and interest rates is known as an inverse relationship.
The longer-term bond’s price varies more than the price of the shorter-term bond when interest rates change because it has more cash flows further into the future that are affected by changes in interest rates. The shorter-term bond has fewer cash flows further into the future that are affected by changes in interest rates.
For example, let’s say you have two bonds with a face value of $1,000 each and an 11% annual coupon. Bond L matures in 12 years, while Bond S matures in 1 year. If the going interest rate is 6%, 8%, and 12%, then Bond S would be worth $1,106.00, $1,089.00, and $1,063.00 respectively. Bond L would be worth $1,321.97, $1,178.64, and $1,000.00 respectively.
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