Question

You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (Ja sequence of three one year bonds: (i) a three year bond; or (i) a two-year bond followed by a one-year bond. The current yield curve tells you that the one year, two year, and three year yields to maturity are 2.5 percent. 4 percent, and 2.7 percent respectively. You expect that one-year interest rates will be 5 percent next year and 5 percent the year after that. Assuming annual compounding. compute the return on each of the three investments Instructions: Enter your responses rounded to the nearest two decimal places. Expected return for (1) = 250% Expected return for (i) = 0 % Expected return for (-0 %

Answer 1

(i)

Expected return = (1 + current 1-year yield) * (1 + 1-year interest rate after 1 year) * (1 + 1-year interest rate after 2 years) - 1

Expected return = (1 + 2.5%) * (1 + 5%) * (1 + 5%) - 1

Expected return = 13.01%

(ii)

Expected return = (1 + current 3-year yield)³ - 1

Expected return = (1 + 2.7%)³ - 1

Expected return = 8.32%

(iii)

Expected return = (1 + current 2-year yield)² * (1 + 1-year interest rate after 2 years) - 1

Expected return = (1 + 4%)² * (1 + 5%) - 1

Expected return = 13.57%