Suppose that you are considering investing in a four-year bond that has a face value of $1,000 and a coupon rate of 6%.
a. What is the price of the bond if the market interest rate on similar bonds is 6%? What is the bond's current yield?
b. Suppose that you purchase the bond, and the next day the market interest rate on similar bonds falls to 5%. What will the price of your bond be now? What will its current yield be?
c. Now suppose that one year has gone by since you bought the bond, and you have received the first coupon payment. How much would another investor now be willing to pay for the bond? What was your total return on the bond? If another investor had bought the bond a year ago for the amount that you calculated in (b), what would that investor's total return have been?
d. Now suppose that two years have gone by since you bought the bond and that you have received the first two coupon payments. At this point, the market interest rate on similar bonds unexpectedly rises to 10%. How much would another investor be willing to pay for your bond? What will the bond's current yield be over the next year? Suppose that another investor had bought the bond at the price you calculated in (c). What would that investor's total return have been over the past year?