7.Now consider what would happen if your horizon was just one year. If you invest all of your $1,000,000 in Bond A, how much money will you have from that investment at t = 1 (i.e., after one year) if the one-year rate next year is the forward rate?Note that, because your horizon is only one year, you will have to sell the bond before it matures at t = 2, at a sales price that depends upon the interest rates that prevail at t = 1.Assume that the market prices of all bond are always equal to the present value of the remaining payments using the appropriate rates off the zero yield curve.

8.Next, similar to 7 above, how much would you have at t = 1 if you invest all of your $1,000,000 in Bond B?

9.By comparing your answers to 7 and 8, do you prefer one bond over the other?

10.How do your answers to 6 and 9 make you feel about the YTM differences calculated in 2 and 3?

11.Redo all of your calculations in 4 - 9, but assume that the one-year rate that actually occurs next year is the forward rate plus .005 (i.e., higher by a half a percentage point).

12.Redo all of your calculation in 4 - 9, but assume that the one-year rate that actually occurs next year is the forward rate minus .005 (i.e., lower by half a percentage point).

13.Summary: You cannot perfectly predict the future one-year rate and, in fact, you face the uncertainty that the one-year rate next year will be the forward rate off the current yield curve plus or minus half a percentage point (where both outcomes are equally likely). How does that uncertainty effect the risk of each bond?Specifically, given all of the calculations and comparisons above, how does the magnitude of variation in what you get depend upon your horizon (either t = 1 or t = 2) and how does it depend upon the coupon rate (high or low)?