You have a 5-year investment holding horizon and would like to earn a 6% annual compound return each year, and you have a choice between two bonds. Whatever money you have to invest will be invested in one type of bonds or another.
Find the Price, Duration and Modified Duration for each bond, and answer the following questions (show your work and answer the questions below)
Bond 1 has a 6% annual coupon rate, $1000 maturity value, n = 5 years. The market rate for similar bonds (y)= 6% (pays a $60 annual coupon at the end of each year and $1,000 maturity payment at maturity).
Bond 2 is a zero coupon bond with a $1000 maturity value, and n = 5 years, and the market rate for similar bonds (y) is 6% with a $1,000 maturity payment at maturity (pays no coupon payments).
a. Price Bond 1 ______________ Price Bond 2 _____________
b. Duration Bond 1 ______________ Duration Bond 2 ____________
c. Modified Duration Bond 1 ______ _ Modified Duration Bond 2 ____________
(Be sure to show your work for the bond price and duration calculations for credit).
d. Which of the two bonds should you choose for your 5-year investment horizon to duration match to ensure your desired 6% annual compound return if you hold either bond to the end of 5 years? Explain why (assume the same default risk for each bond).
__________________________________________
e. If interest rates go up by 1%, what will be the % Change in the market value for each Bond’s Price? (Hint Change in Price % = - Modified Duration x Change in Rate (expressed as a fraction, i.e. .01).
% Change in Price for Bond 1 ________% Change in Price for Bond 2 ____________
f. Which of the 2 bonds has more price risk, and which has more reinvestment risk?
Explain why.____________________________________________