Practice Problem Test 1

Use the following information (and ONLY the following information) to answer the questions at the end. Assume you have a bond portfolio, which consists of coupon bearing U.S. Treasury and corporate bonds. The bonds are either default risk free or carry a AAA rating. They are exposed to interest rate risk (price and reinvestment risk). You must interpret the information, and where appropriate, act as if you have information the rest of the market does not have. For purposes of this exercise, you need to spend the money in 3 years.

You have the following information:

1. The latest GDP growth forecast (just out) for the upcoming year is 0.7%; this is a reduction in forecast growth from the prior expected rate of 1.1%. Corporate capital investment is projected to decline, and the labor market is expected to slacken slightly. The Fed may intervene at some point this year.
2. Japan will have weaker growth than the U.S., their GDP is projected to decline by 1.2%, but you expect Europe to begin growing faster than the U.S., with Britain leading the way. The Euro is projected to strengthen slightly against the dollar, but the yen will probably be purposefully devalued against the dollar, and overall the dollar will probably strengthen.

1. Analyze each of the bits of information separately and briefly state what the effect of each will be on U.S. interest rates using our supply and demand framework. Clearly explain why indicating whether the effect is predominantly a supply or demand change.

The average promised yield on your bond portfolio is 7%, however, you wish to try to earn a higher rate if possible. Based upon your summary above, which of the following durations do you recommend? EXPLAIN WHY. Duration 5 years Duration 3 years Duration 1 year