Final answer:
To determine the expected annual return on the bond in question, one must compute the total coupon payments, reinvest at 4%, estimate the bond's future price, and calculate the return over the original investment over three years.
Step-by-step explanation:
The question pertains to the expected annual return over the next three years for a $1,000 par value bond that pays a 6% coupon rate annually and currently has a yield to maturity (YTM) of 6.7%. The student anticipates that the bond's YTM will drop to 5.9% in three years and that coupon payments can be reinvested at a rate of 4% per year. To calculate the expected annual return, one must consider the bond's future value, including the reinvested coupons, the expected price change due to the change in YTM, and divide the total profit by the original investment to get the average annual return.
Here is a simplified formula to use for the calculation:
- Determine the total coupon payments over the next three years.
- Calculate the future value of reinvested coupons at a 4% annual rate.
- Estimate the bond's price after three years based on the expected YTM of 5.9%.
- Combine the future value of reinvested coupons and the estimated price change to get the total future value.
- Calculate the total profit by subtracting the original investment from the total future value.
- Divide the total profit by the original investment and then by the number of years to find the average annual return.
The actual calculation requires more detailed financial computation and understanding of bond pricing and reinvestment strategies to reach the precise figure for the expected annual return.