Consider the following two bonds: a 5-year and a 10-year bond,each with a 7% coupon. Both bonds currently sell at par and couponpayments are made annually (i.e., one coupon payment per year).
(a) What is the current price of each bond?
Hint: answer does not require calculations; read description ofbonds carefully to determine what price must be (10 points) Supposeyou buy the 10-year bond. One year later, interest rates decreaseto 5%.
(b) What will be the new price of the bond? (30 points)
(c) What rate of return would you have earned on the bond overthe one-year period? (20 points)
(d) Which bond will have a higher rate of return over the year,the 5-year bond or the 10-year bond? Why? (5 points).
You don’t need calculations for this one and will not be givenany points for a numerical answer; respond based on yourunderstanding of interest rate risk (price sensitivity) inbonds.
