Final answer:
To determine the bond's price, discount the future cash flows at the current and expected future market yields. The holding period return includes both the coupon payments and the capital gains due to price changes of the bond. This total return is exemplified by a hypothetical yield calculation based on cash inflows and the investment amount.
Step-by-step explanation:
Finding the Price of a Bond Today and in One Year
To find the price of a bond today, we need to discount the expected future cash flows of the bond at the current market yield of 8%. The bond pays a 6% coupon on a $1,000 face value, which equates to annual payments of $60. The present value of these payments plus the face value, all discounted at the 8% yield, will give us the bond's price today.
In one year, if the market yield decreases to 7%, the bond's price should increase since the future cash flows will be discounted at a lower rate. We would recalculate the bond's price, similarly discounting the remaining cash flows (including the final year's coupon payment and the face value repayment) at the new yield of 7%.
The holding period return is then calculated by adding the received coupon payment from the first year to the capital gain (or loss) resulting from the change in the bond's price over that year. The return is expressed as a percentage of the initial investment.
Using the referenced example, if the investor receives the $1,000 face value plus $80 for the last year's interest payment, making the expected total cash inflow $1,080, and the bond was purchased at $964, the yield on the bond would be calculated using the formula ($1,080 - $964) / $964 = 12%. This represents the total return, which includes both interest payments and capital gains.