Question

You are given the following information on the bond market:

Money available on January 1, 2013: $1,000 Interest rates on January 1, 2013, on bonds of different maturities: one year, 4 percent; two years, 5 percent; three years, 5.5 percent; four years, 6 percent

Note: Consider these to be bonds that compound the interest at the rate given, that is, the three-year bond pays $1,000 3 1.0553 at maturity

Expected future interest rates on one-year bonds:

January 1, 2014: 6.5 percent

January 1, 2015: 7 percent

January 1, 2016: 9 percent Investment horizon: four years, ending January 1, 2017.

What should an investor buy to yield the largest stream of expected income over the period from January 1, 2013, to January 1, 2017?

How would your answer to above change if there is a $10 transactions cost for every bond purchased? In other words, if an investor has $1,000 now, she can spend only $990 on a bond because $10 goes for transactions costs. Each time she buys a new bond, she incurs the $10 fee.

Answer 1

Money Available on January 1, 2013: $1000

1. Interest Rate on January 1, 2013 on 1 Year Maturity: 4%

Future Interest Rate on 1 Year Bond: (4+6.5+7+9)/4

= 6.6%

Future Value for Four Years = $1000 (1.066)^4

= $1291.3

2. Interest Rate on 2 Year Maturity: 5%

Future Interest Rate on 2 year Bond: (5+5+7+9)/4

= 6.5%

Future Value for Four Years = $1000 (1.065)^4

= $1286.46

Thus, the maximum yield can be generated if investor buy bond in early year and take the maximum benefit of Interest.

Our Answer will remain same even if $10 fees will be deducted from all invested bonds as the return will remain same for all the bonds.