QUESTION 3: BONDS (20 points)

Suppose the US issues a consol that promises to pay $10 each year.The price of the consol in the secondary market is $1000.

a.What is the consol's yield to maturity? Justify your answer.

$10/$1000*100%=1%

b.What is the consol's duration?Justify your answer.

c.Consider a coupon bond with a $20 coupon and a face value of $2000.What is its current price, if its yield to maturity is the same as the consol's? Justify your answer.

In the remaining parts, you should assume that the Congressional Budget Office (CBO) suddenly issues a new report warning that the US faces a very high risk of a debt crisis in the next thirty years.You should illustrate all of your answers on a bond supply-demand picture.

d.Show how the demand curve for the consol in the secondary market would shift in response to the CBO report?Briefly (in 2-3 sentence) justify your answer.

e.Show how the supply curve for the consol in the secondary market would shift in response to the CBO report? Briefly (in 2-3 sentence) justify your answer.

f.Given your answers in parts (d) and (e), use the bond supply-demand picture to explain how the new report will affect the consol's price and yield to maturity.