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    The Garraty Company has two bond issues outstanding. Both bonds pay $100 annual interest plus $1,000 at maturity. Bond L has a maturity of 15 years, and Bond S a maturity of 1 year.

    a. What will be the value of each of these bonds when the going rate of interest is (1) 5 percent,
    (2) 8 percent, and (3) 12 percent? Assume that there is only one more interest payment to be made on Bond S.

    b. Why does the longer-term (15-year) bond fluctuate more when interest rates change than? Does the shorter-term bond (1-year)?

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    Solution Preview

    The value of a bond is simply the present value of its stream of payments.

    Let's call R to the interest rate. We know that bond L will pays $100 per year. I'll assume here that this payment is done at the end of each year. So, when the bond matures (15 years from today) we'll receive a $100 payment plus the $1,000. The stream of payments from this bond is:

    Year 1: $100
    Year 2: $100
    Year 15: $100 + $1,000 = $1,100

    Let's assume that we're at year 0, so the first payment on bond L will ...