Finally, after graduation you got your 1st job and discovered that now you can start saving (investing). You decided to buy a 1 coupon bond (right after 1st coupon payment), which had already been issued one year ago. This bond promises to pay to its holder $1,000 in 4 years from the original issue day and make periodic interest payments of 10%. The prevailing market interest rate at the time of bond’s issue was 10%; however, 1 day right after paying the 1st interest payment the prevailing market interest rate on bonds with similar features & risk characteristics declined to 8%.
Unfortunately, one year from the day you acquired the bond you realized that it’s time to start paying off your student loans for which you did not save. As it turns out, the income produced by the bond is not nearly enough to start making those payments. The only option you have at this point in time is to liquidate your investment position in the bond you’re holding. To your surprise the prevailing market interest rate on the bonds of equal risk characteristic & similar features rose up to 12% precisely one day after you collected your interest payment.
A. If you were to sell this bond on the 1st day after you received your interest income, what would be your total rate of return?
B. If you could in fact hold this contract until it expires, but had no chance to re-invest the interest payments, what would be your total return?
C. If you held this contract until the maturity and reinvested each interest income by the prevailing interest rate (assume no change in YTM after the time period t2), what would be your total return?