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Consider a bond that pays coupon interest of $45 at the end of each six month period and that has a face value of $1000. The bond will mature twenty years from today. The appropriate discount rate, based on today’s capital market opportunities, is a simple rate of 7% per year, with semiannual compounding. (a) What is today’s market value of this bond? (b) Explain intuitively why the bond’s current market value differs from its $1000 face value. (c) Suppose that this bond paid coupon interest in the amount of $90 at the end of each year instead of $45 at the end of each six month period. (Note, the Excel spreadsheet will no longer give the correct answer without modification, since it assumes semiannual payments). Effective market interest rates are the same as in part (a) — we are changing the characteristics of this bond, not rates that are available on alternative investments. Recompute the value of the bond, and explain intuitively why the answer differs from that obtained in part (a). Hint: today’s value of the future payment of the bond’s face value should be the same as in part (a), because nothing about this payment has changed.
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