Have been trying to read a book on bonds and the maths connected with it. I understand the basics of bonds but got puzzled by this:
This is a case where the interest rate is 8% but the yield is 9% and you have to calculate the price where the par value is £1,000 with a four years to maturity:
Annual interest is 0.08 x 1000 = 80 and n(period in years)=4
So to work out price the book says: PV (present value) = 80/(1.09)^1 + 80/(1.09)^2 + 80/(1.09)^3 + 1,000/(1.09)^4 = 976.40
So I don't quite get why that process gives us the new price although I understand that the lower the price the higher the yield because the initial interest rate as an absolute value is £80 and if the price lowers that £80 will represent a bigger yield. But I still don't get the formula which divided the interest rate by 1.09 compounding each of three years then adding the par amount plus interest divided by 1.09 compounded for 4 years.
Any help appreciated.
This is a case where the interest rate is 8% but the yield is 9% and you have to calculate the price where the par value is £1,000 with a four years to maturity:
Annual interest is 0.08 x 1000 = 80 and n(period in years)=4
So to work out price the book says: PV (present value) = 80/(1.09)^1 + 80/(1.09)^2 + 80/(1.09)^3 + 1,000/(1.09)^4 = 976.40
So I don't quite get why that process gives us the new price although I understand that the lower the price the higher the yield because the initial interest rate as an absolute value is £80 and if the price lowers that £80 will represent a bigger yield. But I still don't get the formula which divided the interest rate by 1.09 compounding each of three years then adding the par amount plus interest divided by 1.09 compounded for 4 years.
Any help appreciated.