Question 2

(a) How does a bond issuer decide on the appropriate coupon rate to set on its bonds? Explain the difference between the coupon rate and the required rate of return on a bond. (10 marks)

(b) Explain what is meant by the Fisher effect. An investment offers a 12% total return over the coming year. You believe the total real return on this investment will only be 7%. What do you believe the inflation rate will be over the next year? (10 marks)

(c) Suppose you have a semi-annual coupon bond that matures in 8 years. If the bond has a coupon rate of 12% and a yield to maturity of 16%, what is the current price of the bond? If the yield to maturity suddenly falls to 10%, what will happen to the price of the bond? Explain your answer fully.