1. A person holds a two period bond which pays coupon C at the end of...

1. A person holds a two period bond which pays coupon C at the end of each period. Expected interest rate for each of these periods is i. Find price of bond today

2. interest changes to I' in second period. Evaluate rates of return when the person sells the bond after period 1 in the following two cases- change anticipated and change not unanticipated

Expert Solution

Question 1

The price of a bond is the sum of the present value of the par value repaid at maturity and the coupon payments made.

The price of a bond can be expressed as:

Where: P is the bond price, C is the coupon payment, i is the interest rate,M is the maturity value, n is the no. of period and N is the end time period.

Here, we can write the following for P, the price of the bond today:

Question 2

Interest rate changes to i' in the second period. The person decides to sell the bond.

Case 1: Change has been anticipated.

This implies that the investor is expecting a rise in the interest rate. A rise in the interest rate would reduce the bond price. In order to avoid this loss, the investor sells the bond after year 1.This implies: i'>i

Case 2: Change has not been anticipated

Since the change has not been anticipated and the investor chose to sell the bond, there could be two scenarios that could exist: 1) Rising interest rates: Thus, i'>i or 2) Falling interest rate: i'<i.

jeff jeffy answered 2 years ago

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