Suppose that you are considering the purchase of a coupon bond that has a $600 coupon payment every year for 4 years and a $10,000 face value in the 4th year. Suppose the yield to maturity of this bond equals to the market interest rate.
What is the bond worth today if the market interest rate is 5%? What is the bond’s current yield?
(Hint: knowing the interest rate, the value of the bond is how much you should pay for the bond—the price of the bond)
Suppose one year has elapsed, you have received the first coupon payment of $600 and the market rate is still 5%. How much would another investor be willing to pay for the bond now? Given the price that the other investor is willing to pay (the price at which you can sell the bond), what was your total rate of return on the bond?
Suppose that one year has elapsed, you have received the first coupon payment of $600 but the market rate suddenly jumps to 7%. In that case how much would another investor be willing to pay for the bond now? What was your total rate of return on the bond?
Compare your answers from b and c, and explain the relation between the yield to maturity (here the market rate) and the price of bond.