Question 2 (25 points). This question is based on the example on interest risk in Slides 10-12 in Lecture 3Part B.

You have a holding period of one year and are choosing among three investment strategies: 1) buy a 1-year zero with a face value of $10,000 and hold it to maturity, 2) buy a 3-year zero with a face value of $10,000 and sell it at the end of the holding period, or 3) buy a 15-year zero with a face value of $20,000 and sell it at the end of the holding period. The current interest rate is 4% for all maturities, and there are three possible scenarios for interest rates at the end of one year: they stay at 4%, they rise to 6%, or they fall to 2%.

Part A) Calculate the holding period yield (HPY) for each investment strategy in each interest scenario by constructing a table just like the one in the sample spreadsheet for this question.

Tips:

1) Fill in cells A4:A6 with the names of the security types. 2) Fill in cells D1, E2, G2, and I2 with the appropriate interest rate data.

3) Fill in cells B4:B6 with the face values of the three bonds and cells C4:C6 with the maturities of the three bonds.

4) Fill in the rest of the table (columns D to I), using the appropriate formulas and cell references.

Part B) What conclusion can you draw from your table about the interest rate risk of the three investment strategies (the risk due to unexpected changes in future interest rates)? Be as specific as possible.

Part C) Suppose your holding period was 3 years instead of one year and the three possible strategies were to 1) buy the 1-year zero and roll it over every year till the end of the holding period, 2) buy the 3-year bond and hold it to maturity, or 3) buy the 15-year bond and sell it at the end of the holding period. How do you think the interest rate risk of these strategies would compare? Explain. (Do not do any calculations. Just try to reason it out.)