Question
The following five (5) questions are based on the following information. You owe a mobster in Chicago money in 5 years. You want to earn
The following five (5) questions are based on the following information.
You owe a mobster in Chicago money in 5 years. You want to earn a little bit on money you set aside to pay this liability. However, you do not know if interest rates will rise or fall. You have two bonds to choose from with semi-annual coupon payments:
Bond A | Bond B | |
Time to maturity (years) | 5 | 6 |
Annual yield to maturity | 4.00% | 4.00% |
Annual coupon payment | 40.00 | 65.94 |
Current price | -1000 | -1000 |
Face value | 1000 | 826.02 |
So we start with two bonds of equal price ($1000) and annual yield to maturity (4.00%).
1. What is the Macaulay duration (in years) for Bond A?
2. What is the Macaulay duration (in years) for Bond B?
3. Which bond should you choose to immunize your bond holdings from interest rate fluctuations?
4. Assume annual yield to maturity drops from 4.00% to 3.00%. What is the total ending wealth of Bond B?
5. Assume annual yield to maturity drops from 4.00% to 3.00%. What is the total ending wealth of Bond A?
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