Stacy Picone is an aggressive bond trader who likes to speculate on interest rate swings. Market interest rates are currently at 7.5%, but she expects them to fall to 5.5% within a year. As a result, Stacy is thinking about buying either a 25-year, zero-coupon bond or a 20-year, 6.0% bond. (Both bonds have $1,000 par values and carry the same agency rating.) Assuming that Stacy wants to maximize capital gains, which of the two issues should she select? What if she wants to maximize the total return (interest income and capital gains) from her investment? Why did one issue provide better capital gains than the other? Based on the duration of each bond, which one should be more price volatile?

The capital gain of the zero-coupon bond is

The capital gain of the coupon-bearing bond is

Assuming that Stacy wants to maximize capital gains, the issue she should select is the (Zero-Coupon bond or coupon bond)

The holding period return of the zero-coupon bond is

The holding period return of the coupon-bearing bond is

she wants to maximize the total holding period return from her investment, the issue she should select is the (Coupon bond or zero-coupon bond)

Why did one issue provide better capital gains than the other

A. Because zero-coupon bonds always increase more than coupon bonds.

B. Because amount invested isn't taken into account.

C.Because one issue has a longer maturity than the other.

B. Because coupon bonds always increase more than zero-coupon bonds.

The duration of a zero coupon bond is always (equal to, less than, greater than) its actual maturity, while the duration of a coupon-bearing bond is always (greater than, less than, equal to) its actual maturity. Therefore, because the maturity of the zero-coupon bond is greater than the coupon-bearing bond, the zero-coupon bond's duration must be (less than equal to greater than) the coupon-bearing bond and thus (less, more) price volatile and (preferable, less preferable) to an investor seeking greater holding period returns based on an expected decrease in interest rates.