Question

Stacy Picone is an aggressive bond trader who likes to speculate on interest rate swings. Market interest rates are currently at 10.0%, but she expects them to fall to 8.0% within a year. As a result, Stacy is thinking about buying either a 25-year, zero-coupon bond or a 20-year, 8.5% bond. (Both bonds have $1,000 par values and carry the same agency rating.) Assuming that Stacy wants to maximize capital gains, which of the two issues should she select? What if she wants to maximize the total return (interest income and capital gains) from her investment? Why did one issue provide better capital gains than the other? Based on the duration of each bond, which one should be more price volatile? The capital gain of the zero-coupon bond is $ (Round to the nearest cent.)

Answer 1

Solution-

Current Yield	10%
Expected Yield	8%
Par Value	1000
Coupon Bond			Zero Coupon Bond
Coupon Rate	8.50%		Term (years)	20
Term (years)	20
Current price	$872.30		Current price	$148.64
Expected Price	$1,048.02		Expected Price	$231.71
Total payoff after one year	$1,133.02		Total payoff after one year	$231.71
Capital Gains	29.9%			55.9%
Duration	9.637			20

As we can see capital gains are higher from Zero coupon bond. This is happening because of the fact that zero coupon bond has higher duration which implies that when interest rate falls the zero coupon bond will result in higher increment in bond price relative to normal coupon paying bond which has lower duration.

Zero coupon bond is more volatile.

Thanks!