Anna Green thinks that the recent Federal Reserve policy is going to push the interest rates...
Anna Green thinks that the recent Federal Reserve policy is going to push the interest rates up. She is considering keeping only one of the three bonds in her portfolio. She knows that bond A has a duration of 5.234, bond B has a duration of 4.867, and bond C has the following characteristics:
Par Value 1,000
Life 5 years
Coupon Rate 5%
Discount rate 14 percent
Which one of the three bonds should she keep? Why? Explain.
Homework Answers
We have to calculate duration of Bond C as follows:
Coupon rate=1,000*5%=$50
| 1 | 2 | 3 | 4=2*3 | 5=2*4 |
| Year | Cash Flow | DF @ 14% | PV | Weighted average |
| 1 | 50 | 0.8772 | 43.8596 | 43.8596 |
| 2 | 50 | 0.7695 | 38.4734 | 76.9468 |
| 3 | 50 | 0.6750 | 33.7486 | 101.2457 |
| 4 | 50 | 0.5921 | 29.6040 | 118.4161 |
| 5 | 1050 | 0.5194 | 545.3371 | 2726.6855 |
| 691.0227 | 3067.1537 |
Duration=3067.1537/691.0227
=4.4386
Anna Green thinks interest rate may rise, which means bond price will fall if Federal Reserve Policy pushes the interest rate up. Which means that she should keep a bond having lowest duration so that the price fall is lowest for increase in interest rate.
Accordingly she should keep Bond C which has the lowest duration amonst the three bonds.
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