Bond Question

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1. Current yield is 6.2% today on a bond that is just issued with 4 years to maturity, 6.5% coupon rate and $1,000 face value. a) (15 points) What will be the price of this bond exactly in two years (after it distributes its second coupon) if the market rate doubles? b) (20 points) How much capital gains should an investor expect to get in the subsequent year if she buys this bond at that time (in two years, after the second coupon is distributed and when the market rate is twice as much as today’s market rate)? 2. There are two bonds on sale the investors can choose from: Bond A: 4-year, 10% coupon rate, $1,000 face value. Bond B: 30-year, 8% coupon rate, $1,000 face value. As we discussed in class, investors may have access to different information or interpret the information differently which would cause them to arrive at different conclusions regarding the evaluation of assets. Assume that investor I sees both bonds as risky investments and asks a promised yield of 12% from each. Investor II does not see them as risky investments. Assume further that the market rate (alternative investment rate) for both investors is 10%. a) (10 points) What would be the maximum price each investor would be willing to pay for each bond today? b) (10 points) Assume that 20% of the investors of type I and 80% of them are of type II. The market price of each bond today is obtained by: 20%* max Price of Investor I + 80% * Max Price of Investor II (Note that this is a pretty good proxy for how the market price would be arrived at in real world) Then, which investor would buy which bond, if any? c) (20 points) Assume one year passes and the first coupons are just distributed. Assume that all uncertainty regarding these bonds have been resolved and it is public information now that the bond issuers will be able to pay all coupons and the face values at the required times. What is the annual return of each investor?

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