Macroeconomics
IndividualDdecidestoinvestinoneofthesebondsinApril2024atitsfacevalueof$1,500.Attheendof 2024,2025,2026,and2027,individualDreceivesa4%couponpayment($1,500x0.04=$60foreach payment).InDecember2027,individualDalsoreceivesthefullfacevalueofthebond.Intotal,individual D earns $240 incouponpaymentsontheinvestmentmade.However,there'sarisktotheinitial$1,500 investment if GreaTech Inc. does not repay the bond at maturity. Sinceabondgeneratesanincomeforitsholder,weshouldbeabletocalculateits rateofreturn ,which is the proft made on it, usually expressed asapercentage .Abond’srateofreturniscalculatedas follows: × 100% − SupposethatindividualEbuysabondwithaparvalueof$120andpays$100forit.Let’salsoassume that this bond doesn’t pay any coupons. Then, the rate of return = × 100% = 20% $120−$100 $100 Thismeansthatuponpurchasingthebond,individualEexpecteda20%return.Thisreturnshouldbeat least as good as any other return individual E could have gotten for their money, such as a savings accountthatalsopays20%.Infact,ifindividualE’sbankinterestrateislessthan20%,thenthebondis even more appealing. The interest receivedfrombondsoranyotherfnancialassetsuchassavingsaccountsrepresents the costofborrowing (fortheborrower)or thereturnonsavingandinvestment (forthelenderorissuer). Consequently, the interest rate is the opportunity cost of holding money . If people decide tokeep money in their safe or pocket instead ofinvestinginabondorasavingsaccount,theywouldlosethe interest rate they could have received instead. The Relationship Between Interest Rates and Bond Prices Although the determination of interest in the fnancial market will be discussed in later parts of this chapter, we need to understand the relationship between interest rates and bond prices. This relationship is a fundamental principle in bond investing and is known as the inverse relationship between interest rates and bond prices . Since bond pricesdifferbetweenthefacevalueandtheactualmarketpriceatwhichthey’retraded,a calculation is needed to align between the two values. This is known as the yield, which is a simple measure of a bond’s income relative to its current price. It is calculated as follows: Rate of return =
( )
Yield =
× 100%
Let's say someone has a bond with the following characteristics:
Par value: $1,000
Annual coupon payment: $50
115
© 2024 ACHIEVE ULTIMATE CREDIT-BY-EXAM GUIDE|MACROECONOMICS
Made with FlippingBook - Online Brochure Maker