Question of the Week

A 6.4% coupon bond that is expected to mature in five years is currently trading at 96.825. If the annualized reinvestment rate is expected to be 5.8%, what will this bond's effective annual total return be?

A) 6.63%
B) 7.17%
C) 7.11%
D) 6.39%

Answer:

The correct answer is: C)

Step 1: Future value of reinvested coupons.

PMT = 3.20; n = 10; I = 2.9%

Therefore, FV = 36.516

Step 2: Total FV at maturity = (FV of coupons + Par)

= 36.516 + 100
= 136.516

Step 3: Calculate Holding Period Return

= 136.156/96.825 - 1 = 40.99%

Step 4: Calculate the effective annual total return

(1.4099)1/5 - 1 = 7.11%

or,

(1.4099)1/10 - 1 = 3.495% (this is the effective 6-month yield)

Therefore, (1.03495)2 - 1 = 7.11%




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