Question

You observe the following term structure: Effective Annual YTM 1-year zero-coupon bond 5.2 % 2-year zero-coupon bond 5.3 3-year zero-coupon bond 5.4 4-year zero-coupon bond 5.5 a. If you believe that the term structure next year will be the same as today’s, calculate the return on (i) the 1-year zero and (ii) the 4-year zero.

Answer 1

Answer:

Explanation:

a. If you believe that the term structure next year will be the same as today’s, calculate the return on (i) the 1-year zero and (ii) the 4-year zero.

b. Which bond provides a greater expected 1-year return? O 1-year zero-coupon bond O 4-year zero-coupon bond

The return on one year bond is = 5.2%

The price of 4 year bond today

$=\frac{ 1000}{ (1.055)^4}$

Price of 4 year bond today = 807.22

If yield curves is unchanged, the bond will have 3-year maturity and price will be

$=\frac{ 1000}{(1.054)^3}$

If yield curves is unchanged, the bond will have 3-year maturity and price will be = 854.04

Return

$=\frac{ (854.04 - 807.22)}{807.22}$

Return = 5.8%

The longer term bond has given the higher return in this case at it's YTM fell during the holding period(4 -year)