XYZ International’s bonds mature in 12 years and pay 7% interest annually. If you purchase the bonds for $1,150, what is your expected rate of return?
To calculate the expected rate of return on a bond, you need to consider the purchase price, the coupon payments received, and the maturity value.
In this case, the bond has a maturity of 12 years and pays 7% interest annually. The purchase price is $1,150.
To find the annual coupon payment, you multiply the face value of the bond (which is the amount you will receive at maturity) by the coupon rate. In this case, it would be 7% of the face value. However, we are not given the face value, so we cannot calculate the exact coupon payment.
However, we can still determine the expected rate of return using some assumptions. Let's assume that the face value of the bond is $1,000 (a common assumption for bonds).
The coupon payment in this case would be 7% of $1,000, which is $70 (0.07 x $1,000).
So, for each year of the bond's life, you will receive a coupon payment of $70. At the end of the 12 years, you will also receive the face value of $1,000.
Now, to calculate the expected rate of return, divide the sum of all the future cash flows by the initial investment (the purchase price).
Expected Rate of Return = (Total Future Cash Flows / Initial Investment) - 1
Total Future Cash Flows = (Annual Coupon Payment x Number of Years) + Face Value
= ($70 x 12) + $1,000
= $840 + $1,000
= $1,840
Expected Rate of Return = ($1,840 / $1,150) - 1
≈ 1.60
Therefore, your expected rate of return on this bond is approximately 1.60 or 160%.