1. (30 points) Interest Rate Risk of Bonds: Consider the example we showed in the...
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1. (30 points) Interest Rate Risk of Bonds: Consider the example we showed in the lecture. Suppose that Investor A bought a x-year coupon bond with a $1,000 face value and a 5% coupon rate at t=0.x>1. The market interest rate at t=0 was 10%. (a) (3 pts) Please plot a timeline to show the cash flow of the bond. (b) (5pts) Denote the price that Investor A paid for the bond at t=0 by P0. Is P0 the same as, larger, or smaller than the face value of the bond? Please explain. (c) (3 pts) If Investor A holds the bond until maturity, what is the rate of return from her investment? (d) (5 pts) Suppose that Investor A sells the bond at t=1 after redeeming the first coupon. The market interest rate decreases to 5% at t=1. Please write down the equation that determines the selling price, P1 of the bond. Note: Please only use the numbers and notations given in the question. (e) (8 pts) Following from (d), please write down the equation for the rate of return of Investor A's investment. Is it larger or smaller than your answer in (c)? Please explain. Note: Please use the numbers and notations in the equation and do not assign random numbers. (f) (6 pts) If x=1 (i.e., a one-year coupon bond), would your answer to (e) change? Please explain
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