Merton is a bond portfolio manager at ABC Capital Partners. His fund recently purchased $500 million principal value of 2-year 12% coupon bonds at par value. Assume that the term structure of interest rates is flat.

Under each of the following 3 scenarios, calculate the actual rate of return earned on this bond investment, assuming ABC Capital Partners holds the bonds until maturity.

A. Assume the term structure instantaneously shifts from 12% to 17%. Compute the new price of the bonds. Assume ABC Capital Partners holds the bonds until maturity. Compute the holding period return for the bonds assuming the term structure remains at 17% over the
holding period.

B. Repeat part A assuming an instantaneous shift from 12% to 7%.

C. Explain the roles of interest rate risk and reinvestment rate risk in this example.