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Consider the following discount bonds: Bond A: a discount bond that pays $10,000 one year from now. Bond B: a discount bond that pays $10,000
Consider the following discount bonds: Bond A: a discount bond that pays $10,000 one year from now. Bond B: a discount bond that pays $10,000 two years from now. Bond C: a discount bond that pays $10,000 five years from now. a. (4pt) If the current interest rate for one-, two-, and five-year discount bonds is 4%, what is the current price of each bond, respectively? b. (4pt) Suppose that one year from now the market interest rate for one-, two-, and five-year discount bonds rises to 7%. What will the price of each bond be one year from now, respectively? c. (4pt) According to your answers in part a. and part b., what is the rate of return of holding each bond for one year, respectively? d. According to your answers in previous parts (i.e. part a, b, and c). i. (1pt) What can you conclude about the interest-rate risk if the holding period matches the term to maturity? ii. (2pt) How does an increase in the interest rate affect the rate of return when the holding period is shorter than the term to maturity? What else can you conclude about the interest-rate risk in this situation? e. Suppose that Bob has a holding period of two-year and can choose either the roll-over strategy or the buy-and- hold strategy to invest $10,000 in bonds today. i. (2pt) If the current market interest rate for two-year discount bonds is 4% and Bob chooses the buy-and- hold strategy, what is the annual rate of return? [Hint: Bob's holding period here matches the term to maturity.] ii. (2pt) If the market interest rate for one-year discount bonds is 4% now and will rise to 7% one year from now, what is the annual rate of return under the roll-over strategy? iii. (2pt) According to your answers to parts e.i. and e.ii., how does an increase in the interest rate affect the rate of return? Explain why or why not your answer here is the same as your answer to part d.ii. Consider the following discount bonds: Bond A: a discount bond that pays $10,000 one year from now. Bond B: a discount bond that pays $10,000 two years from now. Bond C: a discount bond that pays $10,000 five years from now. a. (4pt) If the current interest rate for one-, two-, and five-year discount bonds is 4%, what is the current price of each bond, respectively? b. (4pt) Suppose that one year from now the market interest rate for one-, two-, and five-year discount bonds rises to 7%. What will the price of each bond be one year from now, respectively? c. (4pt) According to your answers in part a. and part b., what is the rate of return of holding each bond for one year, respectively? d. According to your answers in previous parts (i.e. part a, b, and c). i. (1pt) What can you conclude about the interest-rate risk if the holding period matches the term to maturity? ii. (2pt) How does an increase in the interest rate affect the rate of return when the holding period is shorter than the term to maturity? What else can you conclude about the interest-rate risk in this situation? e. Suppose that Bob has a holding period of two-year and can choose either the roll-over strategy or the buy-and- hold strategy to invest $10,000 in bonds today. i. (2pt) If the current market interest rate for two-year discount bonds is 4% and Bob chooses the buy-and- hold strategy, what is the annual rate of return? [Hint: Bob's holding period here matches the term to maturity.] ii. (2pt) If the market interest rate for one-year discount bonds is 4% now and will rise to 7% one year from now, what is the annual rate of return under the roll-over strategy? iii. (2pt) According to your answers to parts e.i. and e.ii., how does an increase in the interest rate affect the rate of return? Explain why or why not your answer here is the same as your answer to part d.ii
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