You are a manager of a bond portfolio. As such you consider buying the following two government bonds:

Bond 1: remaining term to maturity 7 years; coupon 3%

Bond 2: remaining term to maturity 5 years; coupon 5%

a. Compute for both bonds their price, their yield to maturity, their duration and their convexity using the spot rates (i.e. yields of zero coupon bonds) given in the table below. You may assume that coupons are paid annually.

b. Compute the bonds holding period returns after one year. Of course, these returns depend upon the future interest rates. Assume the following alternative scenarios:

i. The term structure does not change.

ii. All spot rates increase by 1 percentage point. Are the results consistent with the durations you reported in part 1 of this assignment? Explain.

iii. The term structure changes according to the expectations embedded in the expectation hypothesis (expectations are realised).

iv. The term structure changes according to the expectations embedded in the liquidity preference hypothesis. You may assume that the liquidity premium is a constant equal to 0.10% for all maturities.

Spot Rates

Maturity Spot Rate

1 2.50%

2 2.60%

3 2.70%

4 2.80%

5 2.90%

6 3.00%

7 3.10%

8 3.20%

9 3.30%

10 3.40%