Question

Which of the followin is NOT a reason why the required return on a bond may differ form its par value?

Answer 1

Answer:

C. The required rate of return exceeds the coupon value, so the bonds sells at a premium

Explanation:

The required return on a bond = Yield to maturity (Current Market interest rate) * Bond Par value.

Coupon return = Coupon rate of bond * Par value of bond.

There are two types of returns on bonds-

(1) Required rate of return (Yield to maturity related)

(2) Return from capital gain

If the Yield to maturity (YTM) related return is higher than the coupon return, then return from capital gain will be negative i.e. there will be a capital loss, so the bond will trade below par value (at discount).

If the Yield to maturity (YTM) related return is lower than the coupon return, then return from capital gain will be positive i.e. there will be a capital gain, so the bond will trade above par value (at premium).

Hence, the required return rate (YTM related) and return from capital gain, both cancel out each other in a bond.

So, following the concept only option (c) - the required rate of return exceeds the coupon value, so the bonds sells at a premium is not a reason of why the required return on a bond may differ form its par value.