Question 1 (40 marks) You are considering buying two bonds (Bond A and Bond B) issued by B&B Inc. Both bonds have 15 years remaining to maturity, $1,000 par value and carry an 8% coupon. Bond A is an annual coupon-paying bond while Bond B is quarterly coupon-paying bond.

(a) Explain, without the calculation of the bond price, whether Bond B is trading at premium, par or discount if its YTM is 8%. [Note: Full mark would only be given to answer of no more than TWO lines.] (2 marks)

(b) How much should you pay for Bond A if its YTM is currently 7%? (4 marks)

(c) i) Suppose Bond As YTM is expected to rise to 9% in one year. Compute the bonds current yield, capital gains yield and total yield (i.e., the 1-year holding period yield, HPY1-year). (12 marks)

ii) For Bond A, describe (in NO more than one line) the relationship between current yield, capital gains yield and holding period yield. (2 marks)

(d) Re-do part (ci) assuming the YTM of Bond B rises to 10% in one year and coupons are reinvested at YTM. (18 marks) [Hint: A coupon bonds total return comes from three sources: coupons, reinvestment of coupons and capital gain. What is the total amount of interest income earned for one year if coupons are reinvested at YTM?]

(e) Explain which bond (A or B) has higher interest rate risk. (2 marks) [Note: Full mark would only be given to answer of no more than TWO lines.]