Assume that AT&T’s pension fund managers are considering two alternative securities as investments:

(1) Security Z (for zero intermediate year cash flows), which costs $422.41 today, pays nothing during its 10-year life, and then pays $1,000 at the end of 10 years,

(2) Security B, which has a cost today of $500 and pays $74.50 at the end of each of the next 10 years.

a. What is the rate of return on each security?

b. Assume that the interest rate that AT&T’s pension fund managers can earn on the fund’s money falls to 6 percent immediately after the securities are purchased and is expected to remain at that level for the next 10 years. What would the price of each security be after the change in interest rates?

c. Now assume that the interest rate rises to 12 percent (rather than falls to 6 percent) immediately after the securities are purchased. What would the price of each security be after the change in interest rates? Explain the results.