Consider a coupon bond that pays $50 coupons in two consecutive years (years 1 and 2) and pays its face value of $500 at the end of the second year (year 2). Assume an interest rate of 10% for these two years.
1. Given this information, compute the price of the bond on year 0.
2. Consider an increment of the interest rate from 10% to 15%. Suppose an investor that purchased a bond on year 0, before the change in the interest rate, and sold the bond on year 1, after cashing the first coupon and after the change in the interest rate. Which is the rate of return for this one year investment?
Consider the same situation as before with a single difference. In this second case, the coupon bond pays $50 coupons in three subsequent years (years 1 , 2 and 3) and pays its face value of $500 at the end of the third year (year 3). The bond is bought in period 0 and sold in period 1, after the paid its first coupon. As in the previous exercise, consider an interest rate of 10% at the time in which the bond is purchased and an interest of 15% at the time the bond is sold.
3. Which is the rate of return for this one year investment?
4. Comment cases “2” and “3” referring to the concept of “interest-rate risk”.