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Test 4 2015 Question 2

+1 vote
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asked Oct 29, 2016 in BUS 1003H - Introduction to Financial Risk by Zaba_Mvelase (570 points)

 An investor buys a fixed interest bond at par. The bond pays annual coupons. Which of the following statements is true: $$\\$$ A. The investor cannot make a capital gain on this investment. $$\\$$B. The investor can only make a capital gain if the bond is redeemed at more than par.$$\\$$ C. The investor can make a capital gain if the yield to maturity is higher than the coupon rate. $$\\$$D. None of the above 

1 Answer

+2 votes
answered Oct 29, 2016 by Zaba_Mvelase (570 points)
selected Nov 12 by Richard van Gysen
 
Best answer

Capital gain/loss refers to the difference between the value received when an asset is sold or matures, and the price that was paid to obtain the asset originally.  

If the bond price is greater than face value then:

\(\rightarrow\) The bond is said to trading "above par" or "at a premium"

\(\rightarrow\) Coupon Rate > Yield to Maturity


If the bond price is less than face value then:

\(\rightarrow\) The bond is said to trading "below par" or “at a discount”

\(\rightarrow\) Coupon Rate <Yield to Maturity


If the bond price is equal to face value then:

\(\rightarrow\) The bond is said to trading "at par"

\(\rightarrow\) Coupon Rate = Yield to Maturity


So if an investor buys a bond where the yield to maturity is higher than the coupon rate, this means that the investor can buy it at a discount and there can be a capital gain which is equal to the difference between  face value (when coupon rate=YTM) and the “discount” price.

 

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