Assume you have a one-year investment horizon and are trying to choose among three bonds. All have the same degree of default risk and mature in 10 years. The first is a zero-coupon bond that pays $1,000 at maturity. The second has an 8% coupon rate and pays the $80 coupon once per year. The third has a 10% coupon rate and pays the $100 coupon once per year.
a. If all three bonds are now priced to an 8% market rate, what are their prices?
b. If you expect their market rates to be 8% at the beginning of next year, what will their prices be then? If one of the above bonds were a municipal bond, what additional consideration would need to be made as part of the investment decision?
c. Recalculate your answer to (b) under the assumption that you expect the market rates on each bond to be 7% at the beginning of next year.