Kavita De Falla is an individual with low risk tolerance who has just inherited $100,000. She has no immediate needs for the funds but would like to supplement her current income. Thus, De Falla is considering investing these funds in debt instruments, since the interest and repayment of principal are legal obligations of the issuer. While she realizes that the borrower could default on the payments, she believes this is unlikely, especially if she limits her choices to triple- or double-A-rated bonds. De Falla does realize that she could earn more interest by purchasing lower-rated bonds but is not certain that she is capable of bearing the risk.
1. a) What would be the expected price of each bond one year from now if interest rates were 8 percent?
b) What would be the expected price two years from now if interest rates initially fall but subsequently rise to 12 percent at the end of the second year?
2. If interest rates were expected to fall and not rise back to 12 percent, which alternative is best?
3. If interest rates were expected to decline initially and then rise, which alternative should be selected?
4. If bond A were selected, what would happen after a year elapses? What decision must then be made?