Quick, what's your trade?

Quantitative Finance Level 1

A 5 year, 5% coupon $1000 corporate bond yielding 5% is currently trading for $995. What trade would you want to execute?

Note: Ignore transaction costs and interest rates.

Buy it It is fairly priced Sell it

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Calvin Lin by Calvin Lin

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1 solution

The fair price of the bond should be its nominal value (1000) and in the market they are selling it at 995, this means that the bond is under value, so if we buy now we can expect that in the future the market will show the fair value of the bond and get a profit of 5.

16 Helpful 3 Interesting 6 Brilliant 8 Confused

Buy low, sell high!

Calvin Lin Staff - 6 years, 3 months ago

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Treasury bonds trade at discounts, not coupons. If you buy a $1000 TREASURY bond on the open market with a 5% yield, it will cost you 950. You get $1000 at maturity. So if it were a $1000 TREASURY bond with a 5% yield selling at $995. You would want to sell it. This example is right for most other types of bond. Government bonds work a little differently.

Dan Axelrod - 5 years, 2 months ago

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I agree with Dan's comment. The answer should be changed to reflect this.

Andrei Rotenstein - 3 years, 8 months ago

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@Andrei Rotenstein – Ah thanks. I've edited the question. Those who answered "sell it" have been marked correct.

Calvin Lin Staff - 3 years, 8 months ago

Yep, thats correct.

Jesus Ulises Avelar - 6 years, 3 months ago

If you don't consider transaction costs and the time value of money.

Patrick B - 5 years, 4 months ago

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Thanks. Let me add that in.

Calvin Lin Staff - 5 years, 4 months ago

You need to know more about the interest rate. If the interest rate is high enough, this bond could be selling at a discount. In this sense, it would be better to short this bond and long the treasury zero, making a profit.

Luiz Felipe Guimaraes - 4 years, 7 months ago

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Yes, that is why I added "Ignore interest rates".

Calvin Lin Staff - 4 years, 7 months ago

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But including it in the answer options makes it confusing.

Redmi Note4 - 3 years, 6 months ago

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@Redmi Note4 – That's a fair point. Those who answered "Need to know more about interest rates / transaction costs" have been marked correct. I have removed those options.

Calvin Lin Staff - 3 years, 5 months ago

How can you ignore interest rates in making a decision whether you should buy or sell?

Peter Lydecker - 1 year, 5 months ago

The problem supposes that interest rate is near 0?

Shaoyu Wang - 11 months, 1 week ago

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