Homework 2

Homework 2 - Homework 2 (Due October 12th (please leave...

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Homework 2 (Due October 12th (please leave your homework assignment before 7pm inside the mail slot with my name on the 2 nd floor of the Rich Bldg.) ) Question 1 (40 points): Suppose a bond is traded at a given price P(1). This bond matures in two years and pays a coupon equal to c every 6 months. After it has paid its second coupon (since the time the price traded at P(1)) the issuer of the bond makes an announcement: The two coupons that are left will be paid for sure (plus the bond’s face value when the bond matures). However, there is a probability equal to n the coupon amount c will be paid in six months, and a probability (1-n) the issuer will pay instead, after a year, an amount equal to 2*c plus the face value. Right before the announcement the bond trades at P(2). After this announcement the bond trades at a price P(3). Is P(3) bigger, smaller, or equal to P(2)? Why? Assume a six month discount rate equal to r. Calculate P(3)-P(2) (i.e. the change in the price of the bond as a consequence of the announcement.) Question 2
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Homework 2 - Homework 2 (Due October 12th (please leave...

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