Question

＃1

(a) Explain in words the meaning of the phrase ‘one-year return’ on a bond Calculate the expected one year return on a 10-yr Government coupon bond (5% coupon rate) with a face value of $1000 if interest rates are 3% this year and are expected to fall to 2% next year.

(b) Calculate the expected one-year return on the same bond in (a) if interest rates rise to 3.5% instead of falling.

(c) What is meant by the phrase 'interest rate risk' as it applies to the bond market? Define the term. Which bond is subject 1o more interest rate risk a 5.yr Government bond or a 20-yr Government bond? Provide an explanation (in words) for your answer. The more complete the explanation, the higher the grade.

(d) Calculate and compare the · interest rate risk 'associated with a 5yr-Government coupon bond (4% coupon rate) and a 20-yr Government coupon bond (4% coupon rate). Both with a face value of$1000, if interest rates rise from5% this year to 6% next year. Explain your calculations.

Answer 1

A) One year return on a bond means the return which will be expected from the bond at a given coupon rate and face value after providing for the interest risk.

Expected rate of return for one year on a 10-year government bond is given by:

(0.05*1000) + [ (0.02*1000) - (0.03*1000)]

which is 50+(70-80)

= $40 million

B) Using the same equations as mentioned above

Expected rate of return for one year on a 10-year government bond is given by

(0.05*1000) + [ (0.035*1000) - (0.03*1000)]

= 50 + (35-30)

=$55 million

C) Interest rate risk is the danger that the investors suffer due to a change in the interest rate. Usually, a fluctuation in interest rates may cause a threat to the investors and therefore they usually tend to diversify their portfolio by buying different shares and bonds that mature at different dates.

A 20 year Government bond (long term bond) will be subject to more risk than a 5-year government bond (short term bond). This is because there are chances for the interest rates to fluctuate in a long-time period than a short time period, making the investors lose more money than the short term period.