Question

15.8 You observe the following term structure:

	Effective Annual YTM
1-year zero-coupon bond	7.6	%
2-year zero-coupon bond	7.7
3-year zero-coupon bond	7.8
4-year zero-coupon bond	7.9

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. (Do not round intermediate calculations. Round your answers to 1 decimal place.)

b. Which bond provides a greater expected 1-year return?

• 1-year zero-coupon bond

• 4-year zero-coupon bond

Answer 1

Part A

As it is assumed that term structure of the yield will remain the same next year also, the bond prices will rise of respective maturities to adjust the bond yield to current level. i.e. The current 2 year Coupon Bond will become 1 year zero coupon bond and change in price is illustrated below:

Market price of Zero Coupon Bonds-(Based on Yield to Maturity)
	1 Year Zero Coupon Bond	2 Year Zero Coupon Bond	3 Year Zero Coupon Bond	4 Year Zero Coupon Bond
CP	-92.93	-86.2	-79.75	-73.66
Maturity Proceed	100	0	0	0
		100	0	0
			100	0
				100
YTM	7.6%	7.7%	7.8%	7.9%
(Using IRR Formula)

(Current price is calculated based on current yields by using goal seek in Excel)

Accordingly there will be adjustment in price of 2 Year Zero Coupon Bond will increase to $92.93 which stand today at $86.20 and similar adjustment will happen in 4 year zero coupon Bond.

Part B

Since Yield to maturity calculate all the factors in it and yield to maturity of 4 year Zero Coupon Bond is higher than 2 year Zero Coupon Bond. Hence , expected 1 year return is higher in 4 year Zero Coupon Bond.