Suppose that the borrowing rate that your client faces is 2%. Assume that the S&P500 index has an

expected return of 3% and standard deviation of 15%, that the risk-free rate is 1%.

(a) Explain what a bond is, in particular why it is a xed income security. Explain how to price

them.

(b) Explain why zero-coupon bonds are considered more risky than coupon bonds.

6(c) In the following gure, draw the change in bond prices when the interest rate changes, for the

following bonds (clearly mark which graph refers to which bond):

Bond A: Copuon rate 12%, Maturity 5 years, initial yield-to-maturity: 10%

Bond B: Copuon rate 12%, Maturity 30 years, initial yield-to-maturity: 10%

Bond C: Copuon rate 3%, Maturity 30 years, initial yield-to-maturity: 10%

Bond D: Copuon rate 3%, Maturity 30 years, initial yield-to-maturity: 6%