Question

You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) 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 5.2 percent, 4 percent, and 5.2 percent respectively. You expect that one-year interest rates will be 4 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 (i) = Expected return for (ii) =[ Expected return for (ii) =D % %

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 + 5.2%) * (1 + 4%) * (1 + 5%) - 1

Expected return = 14.88%

(ii)

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

Expected return = (1 + 5.2%)³ - 1

Expected return = 16.43%

(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%