1. Assume the following:

Face value of a bond: $1,000

Coupon rate: 8 %

Annual payment: $80 per year

2. Consider the risk of the bond. If this bond carries no risk, then it would be safe to assume that the bond will

sell for $1,000 when it is issued and pay the purchaser $80 per year until its maturity, at which time the final

interest payment will be made and the original $1,000 will be repaid. Now, assume that over time the

interest rates prevailing in the economy rise to 12% and that there is now only one year left to this bond’s

maturity. This makes the bond an unattractive investment, since an investor can find another bond that

perhaps pays 12%. To induce the investor to buy the 8% bond, the bond seller will lower its price below its

face value of $1,000.

3. Calculate the bond's price when its interest rate is less than the market interest rate. The expected

payments from the bond one year from now are $1,080, because in the bond’s last year the bond's issuer
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