Two bonds have a face value of $1,000 and a maturity of two years. One pays a yearly coupon of $200, whereas the other pays a yearly coupon of $50.
a. If the market interest rate is 8 percent, what will be the prices of the two bonds?
b. If inflation suddenly causes the interest rate to rise to 20 percent, what will be the new prices for the two bonds?
c. Which bond suffers a greater percentage decrease in its price when the interest rate rises? Why?
d. Suppose interest rates suddenly decline to 5 percent. What will be the new prices of the two bonds?
e. With returns at 8 percent, what is the future value of the cash flows from the two bonds? That is, how much money will you have in two years from each of the bonds, taking into account reinvestment of your coupon income at 8 percent for two years plus your final principal repayment at maturity?
f. Suppose the maturities of the two bonds are extended to 10 years. What will be the prices of the two bonds given a required yield of 8 percent?