Suppose that an investor buys a three-year bond with the expectations of constant interest rates during the bond’s lifetime. According to her calculations, the bond price is now $100. The real interest rate expected by the investor is 5%.

a. What happens to the bond price if, following an economic shock, the investor’s expectations about the state of the economy worsen, and she now expects a decline in the interest rate next year, for instance to 3%?

b. What happens to the bond price if the investor expects next year’s change in the interest rate to be cancelled out in the third year, that is, the expected interest rate returns to an expected value of 5%?