A bond is a debt security that is usually issued by parties like companies or governments in order to raise funds to be used for particular purposes. A company borrows money from a certain group and in return gives assurance that it will pay the amount it borrowed plus interest on an earlier agreed time. In general then, a bond functions like an "IOU."
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In order to have a simple understanding of how a bond works, one only need remember these three terms: face or par value, coupon or interest rate and maturity. The par value is the amount that the borrower pays when the bond becomes due. Coupon is simply another term for interest payment. Maturity is the date wherein the borrower will pay the lender the par value of the bond. The date of maturity is agreed upon earlier by both the borrower and lender when the bond is issued.
In the problem, all we know is that my coworker has purchased a bond that has a 10% coupon. Let us assume that the bond my coworker bought has a par value of $10,000 and matures in 5 years. What this means is that my coworker will receive a total of $1,000 of interest per year up to 5 years. Once the 5 years is up, my coworker gets back the original $10,000 used to pay for the bond.
Now we talk about yield. Yield is defined as the return a lender gets for a bond issued. The easiest way to compute this is to divide the coupon amount with the price. So in the problem stated, the yield on the bond that my coworker bought is equal to $1,000/$10,000 or 10%. Take note that yield is not the same as coupon. Coupon is a fixed amount while yield changes with respect to the price. Meaning, if prior to maturity, the price of the bond drops to $5,000 then the coupon is still 10% but the yield is now $1,000/$5,000 or 20%. What this shows is that my coworker would still be receiving $1,000 of interest per year on a bond that is now worth just $5,000.
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