Question

A 10-year zero-coupon bond has a yield of 6 percent. Through a series of unfortunate circumstances, expected inflation rises from 2 percent to 3 percent. (LO4) a. Assuming the nominal yield rises by an amount equal to the rise in expected inflation, compute the change in the price of the bond. b. Suppose that expected inflation is still 2 percent, but the probability that it will move to 3 percent has risen. Describe the consequences for the price of the bond.

Answer 1

a.  The change in the price of the bond is: $55.84; $50.83.

b. The consequences for the price of the bond is: Rise in inflation.

a. The change in the price of the bond:

Bond price when inflation is 2% yield =6%

Hence:

Change in bond price=100/1.06^10

Change in bond price=$55.84

Bond price when inflation is 3% yield =7%

Hence:

Change in bond price=100/1.07^10

Change in bond price=$50.83

b. The consequence for the price of the bond is:

Since their is rise in inflation or rise in the price of goods and service which means that the goods will be more costly.

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