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Suppose there are only two investment alternatives: a bank deposit that pays 4% per year, and a 2-year coupon bond with face value of $1,000 and 9% annual coupon rate. Assume bank deposit and the coupon bond are perfect substitutes. (For all the calculation, please make sure to show all formulas and round the values to 2 decimal places.)
a) Calculate Pi - the market price of the bond at the beginning of year 1.
b) Calculate P: - the market price of the bond at the beginning of year 2.
c) What is the ex-ante (expected) annual rate of return for year 1? What is the ex-ante annual rate of return for year 2? Assume now that at the beginning of year 2, the deposit interest rate unexpectedly rises to 12% annual.
d) Calculate P2*- the new bond price for year 2.
e) Calculate RET1 - the ex-post (realized) rate of return on the bond in year 1.
f) Calculate RET2- the ex-post rate of return on the bond in year 2.
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