Bond 1 is a US Treasury Bond with a 4 percent coupon payment due in 2037. This bond does not have a call provision. The required rate of return on this bond is 4 percent.
Bond 2 is a AAA Corporate Bond. It has a coupon rate of 6 percent also due in 2037. This bond does not have a call provision. The required rate of return on this bond is 6 percent. Both bonds have a face value of $1,000.
1) Which bond is more risky? Defend your answer.
2) What is the value of each bond?
3) Now say that interest rates fall immediately (so the maturity period stays the same) so that the required rate of return on the Treasury bond falls to 3 percent and the required rate of return on the corporate bond falls to 5 percent. Calculate the new prices. Analyze the results.
4) Now say that instead of interest rates falling they rise so that so that the required rate of return on the Treasury bond rises to 5 percent and the required rate of return on the corporate bond rises to 7 percent. Analyze the results.
5) What difference did you see between the outcomes of question 3 and 4?