Question
It is November 2021. You are trying to decide which of the following 4 securities to put into your investment portfolio: a) a 10 year
It is November 2021. You are trying to decide which of the following 4 securities to put into your investment portfolio: a) a 10 year 1.5% coupon rate bond with a face value of 100 trading at a yield to maturity of 1.55%, b) a 30 year 2.5% coupon rate bond with a face value of 100 trading at a yield to maturity of 1.90%, c) a low growth stock paying annual dividends of $11 next year and growing at 2% per year forever being valued with a discount rate of 9.75%; and d) a high growth stock paying annual dividends of $16 next year and growing at 6% per year forever being valued with a discount rate of 10.75%.
You are concerned that the Fed is going to raise interest rates very soon in a way that is not fully expected by the market. You expect that the resulting Fed action will increase the discount rates of all of the above options by 1% (option 1 will trade at a yield to maturity of 2.55%, option 2 will trade at a yield to maturity of 2.90%, option 3 will be valued using a discount rate of 10.75% and option 4 will be valued using a discount rate of 11.75%). Which one of the four options will be affected the most by the change of interest rates on a percentage basis? Which one of the four options will be affected the least (in percentage terms)?
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