Consider a two-year, 5 percent coupon bond selling at par. Answer the following questions.

a. What is the bond’s yield to maturity? What assumption does the yield make regarding the first coupon payment? 

b. Assume that in a year the one-year market rate is 7 percent (this future rate is unknown today; it is assumed to be known to illustrate the reinvestment risk). What is the return a bondholder will earn if she purchased the two-year bond today, reinvested the first coupon payment at that rate, and held the bond to maturity? Compare this return to the yield to maturity.

c. Assume that in a year the one-year market rate is 3 percent. What is the return a bondholder will earn if she purchased the two-year bond today, reinvested the first coupon payment at that rate, and held the bond to maturity? Compare this return to the yield to maturity.