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A bond paying a coupon of 7% is redeemable in five years at nominal value ($100) and is currently trading at $106.62. Estimate its yield (required rate of return).
The internal rate of return approach can be used to obtain r. Since the current price is higher than $100, r must be lower than 7%.
my question is, why is the r must be lower than 7% ? what is the concept behind this? bcs in your lecture, we just mostly start the IRR with 10% rate for the first guess.
If the current market value was the same as the redemption amount (in this case $100), then the return on debt (the yield) would be the same as the coupon rate (in this case 7%). This is always true (and you can check for yourself 🙂 )
The market value is the PV of the future receipts discounted at the required return, and as always with discounting the higher the interest rate the lower the PV (and vice versa). Here the MV is higher than the redemption amount and therefore the yield is lower than the coupon rate.
I only usually start with 10% as my first ‘guess’ simply because it is in the middle of the tables. It doesn’t matter which two guesses you use in the exam, just as when calculating the IRR for a project.
Okay, i think i kind of got what you meant..but just to confirm,
1. So, in the case of MV lower than redemption amount, does it means yield will be higher than coupon rate?
2. The higher the YTM, the lower the MV? – inverse relationship
3. back to the first question, if i were to take the first guess 10%, NPV -17.98 and second guess 5%, NPV +2.08 which result to IRR (YTM) = 5.5%
Is it still the correct answer? (in the technical article the answer estimated is 5.46%)
For both posts, the answer is yes.
You should remember from Paper FM (was F9) and from Paper MA (was F2) that when the IRR is calculated using two guesses, then the answer is always only an approximation because the relationship is not linear.
Yeah, i keep on confusing on easy part for reassurance.
Thank you so much for replying all my questions! Bless you 🙂
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