Suppose that the interest rate is 10%. Currently a 5 year coupon bond with annual coupons (the first one is due in 1 year) and face value of $1,000 is selling at par.

Question:

A year from now interest rates will depend on the stance of monetary policy. If monetary policy is tight, the interest rate will be 12%. If monetary policy is loose, the interest rate will be 8%. If you sell the bond a year from now, when monetary policy is tight, what will be the return (HPR=Holding Period Return) on your investment over the year? If you sell the bond a year from now when monetary policy is loose, what will be the return (HPR) on your investment over the year?

Comment: the HPR on a bond from time t to time t+1 is defined as:

Pi+1+ Ct+1 H PRt.t+1=