Because the fair value of a deep discount bond does not change along a straight line as time changes, holding interest rates constant. Suppose you have a bond that pays no interest for 5 years. The interest rate is 10%. Below are the “fair values” of the bond for each year:
Year 0 – 62.09
Year 1 – 68.30
Year 2 – 75.13
Year 3 – 82.64
Year 4 – 90.91
Year 5 – 100
A straight-line amortization would be 7.58 per year – too high for the initial years and too low for later years.
Because the fair value of a deep discount bond does not change along a straight line as time changes, holding interest rates constant. Suppose you have a bond that pays no interest for 5 years. The interest rate is 10%. Below are the “fair values” of the bond for each year:
Year 0 – 62.09
Year 1 – 68.30
Year 2 – 75.13
Year 3 – 82.64
Year 4 – 90.91
Year 5 – 100
A straight-line amortization would be 7.58 per year – too high for the initial years and too low for later years.
StopSpending | Aug 26, 2009 | Reply