At t=0, you purchase a six-yea

At t=0, you purchase a six-year, 7 percent coupon bond (paid annually) that is priced to yield 6 percent (0.06) annually compounded (YTM = 6% or 0.06 annually compounded). The face value of the bond is $1,000. The bond issuer is the U.S. government (no liquidity risk). You are also given that your holding period (investment horizon) equals to the maturity of the bond (t=T=6 years).

a.What is the bond price in U.S. dollars at time t=0?

b.Suppose that the market interest rate increases to 6.875 percent annually compounded (increase by 87.5 basis points) during the first year of your purchase (within year 1), and it remains at that level (6.875 percent) for the next five years.

Assume that, the reinvestment rate for the first coupon payment is the new interest rate, that is, 6.875 percent annually compounded. In addition, you will reinvest the coupon payments in a zero-coupon bond.

What is the your total proceeds (both from reinvestment of coupon payments plus face value) at the end of your investment horizon (t=6) years?

c.Suppose that the market interest rate increases to 6.875 percent annually compounded (increase by 87.5 basis points) during the first year of your purchase (within year 1), and it remains at that level (6.875 percent) for the next five years.

Assume that, the reinvestment rate for the first coupon payment is the new interest rate, that is, 6.875 percent annually compounded. In addition, you will reinvest the coupon payments in a zero-coupon bond.

Now, what is your annually compounded holding period return (HPR) at the end of your investment horizon (t=6) years?

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