Question 8.1 (WILL UPVOTE FOR CORRECT RESPONSE)

1. Bond price elasticity Suppose you want to compare the price sensitivity of two 10-year bonds.

Bond A Has a par value of $1,000. Has a coupon rate of 5 percent with coupon payments made annually. The initial required rate of return, k, is 8 percent.

Bond B Has a par value of $1,000. Has a coupon rate of 10 percent with coupon payments made annually. The initial required rate of return, k, is 8 percent.

Suppose the U.S. announces that it expects the unemployment rate to increase significantly this year, which results in an investors required rate of return on a bond to decrease to 7%.

Bonds:	Initial Price of Bonds when k=8%k=8%	Price of Bonds when k=7%k=7%	Percentage Change in Bond Price	Percentage Change in kk	Bond Price Elasticity (Pbe)(Pbe)
Bond A	$798.70	$859.53
Bond B	$1,134.20	$1,210.71

Now suppose that instead the U.S. announces that it expects the unemployment rate to decrease significantly this year, which results in an investors required rate of return on a bond to increase to 11%.

Using this information, fill in the values for the percentage change in bond price, percentage change in kk, and bond price elasticity for each bond in the table.

Bonds with a Coupon Rate of:	Initial Price of Bonds when k=8%k=8%	Price of Bonds when k=11%k=11%	Percentage Change in Bond Price	Percentage Change in kk	Bond Price Elasticity (Pbe)(Pbe)
Bond A	$798.70	$646.65
Bond B	$1,134.20	$941.11

Based on the calculations, it can be said that the bond price elasticity is (NEGATIVE / POSITIVE) in each scenario, which reflects (A DIRECT / INVERSE) relationship between interest rate movements and bond price movements.

The price elasticity of bond B with a required rate of return of 11 percent can be interpreted as:

A. A 1 percent increase in interest rates leads to a 0.454 percent increase in the price of the bond.

B. A 1 percent decrease in interest rates leads to a 0.454 percent decrease in the price of the bond.

C. A 1 percent increase in interest rates leads to a 0.508 percent decrease in the price of the bond.

D. A 1 percent increase in interest rates leads to a 0.454 percent decrease in the price of the bond.

Based on the calculations, it can be said that a bond with a low required rate of return is (LESS / MORE ) price sensitive than a bond with a high required rate of return.