Q7:

Assume you purchased a 20-year 4% coupon bond with semiannual coupon payments when the YTM was 6%. One day after purchasing the bond, the interest rate dropped by 1% and there would be no further interest rate change for the next 20 years.

1. If you plan to hold this bond to its maturity, what will be your expected rate of return?

2. If you want to lock-in the 6% yield, what is your planned investment horizon? (Show your work/calculation of the rate of return from this investment horizon).

3. Assume you have a lump sum liability due in 15 years. The interest rate on that liability is 5.2%. You are forming an immunized portfolio now to match that liability. You are considering using a 20-year 4% coupon Treasury bond (with semiannual coupon payments) currently selling at 6% YTM and a high-grade preferred stock currently paying 6% dividend yield to form that immunized portfolio. How will you allocate the bond and the preferred stock in the immunized portfolio?