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In this question you will compare three investment strategies in a situation where interest rates are expected to rise. Many investors consider the lock-in to
In this question you will compare three investment strategies in a situation where interest rates are expected to rise. Many investors consider the lock-in to be inferior when rates rise because of interest rate risk. What you will see in this example is that anticipated rate increases are priced into the yield curve and so all strategies are equivalent. However, with unanticipated rate increases there is a dominant investment strategy. Use the data in the table for zero coupon bonds below to complete parts (a) through (h). Spot Rate Yields and Prices Maturity Price (FV = $100) Yield $92.593 8% $84.946 8.5% 1 2 The retur earned (per annum) on the 2-year bond over the two years is % (Do not round until the final answer. Then round to two decimal places) b) Assume that the expectations theory holds (no maturity preference premium). What is the market's consensus expectation for the 1-year spot rate in the second year? (Do not round until the final answer. Then round to three decimal places.) c) Strategy 2: Bailing out of the Lock-in. Solve for the bond price at the end of Year 1. You buy the 2-year bond at time 0. A year passes and the central bank fulfils expectations and announces an increase in interest rates to 9.002%. The 1-year spot rate rises to 9.002%. What price will your 2-year zero coupon bond trade for at datot 1)? (Do not round until the final answer. Then round to three decimal places.) d) Strategy 2: Bailing out of the Lock-in. Solve for the return if you sold att 1. Assume that everything unfolds as described in the last question What is your holding period return for the first year if you sell your 2-year bond att 1? The holding period return wdll be % (Do not round until the final answer. Then round to two decimal places.) e) Strategy 2: Bailing out of the Lock-in. Solve for the return over the 2 Years. You buy the 2-year bon A year passes and the central bank fulfils expectations and announces an increase in interest rates to 9.002%. The 1-year spot rate rises to 9.002%. You sell your bond for the price determined in part (b). You take the money and buy a 1-year bond at t = 1. (What price will you pay for that bond?). You hold that bond until it matures att 2. What is your compound annual average return over the two years? Click to select your answer(s)
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