In January 2006, three bond investors, Mary Isaacs, Katie Ingersoll, and Ron Ip,

Question

In January 2006, three bond investors, Mary Isaacs, Katie Ingersoll, and Ron Ip, each bought $1 million worth of bonds. All bonds in this question have an annual coupon period. All three bond investors bought only newly issued bonds, and the bonds were all sold for face value and hence had coupon rates equal to their yields when issued. They neither added money to their bond investing accounts nor took any out: they reinvested any coupon or principal repayments according to the strategies below, until January 2009, when they compared their wealth. Every January, Mary invested everything in bonds with a 1-year maturity. Katie always bought bonds with maturity January 2009. In January 2006, Ron bought bonds with a 5-year maturity. He did so again in January 2007. In January 2008, he bought bonds with a 1-year maturity. Mary and Katie never sold any bonds before maturity. Ron only sold bonds that hadn't matured yet in January 2009. The table below shows yield curves each January. How much money did Mary, Katie, and Ron each have in January 2009? Who took on the least interest-rate and reinvestment risk? Who took on the most? Explain your reasoning.

Explanation / Answer

Answer-a Mary Isaacs Every year Mary invested everything in bonds with a 1-year of maturity Mary Money(million) Cash flow for 2006 1 Yr bond Cash flow for 2007 1 Yr bond Cash flow for 2008 1 Yr bond Jan.2006 1 -1 Jan.2007 1.044 -1.044 Jan.2008 1.0962 -1.0962 Jan.2009 1.128 1.128 Cash flow for 2006 1 yr Bond in Jan 2007: CF = I * FV + FV when FV = 1 and I = 4.4% = 1.044 Cash flow for 2006 1 yr Bond in Jan 2007: CF = I * FV + FV when FV = 1.044 and I = 5% = 1.0962 Cash flow for 2006 1 yr Bond in Jan 2007: CF = I * FV + FV when FV = 1 and I = 2.9% = 1.1280 Katie Every year Katie invested everything in bonds with maturity in 2009 Katie Money(million) Cash flow for 2006 1 Yr bond Cash flow for 2007 1 Yr bond Cash flow for 2008 1 Yr bond Jan.2006 1 -1 Jan.2007 0.043 -0.043 Jan.2008 0.043 0.0021 -0.0451 Jan.2009 1.135 1.043 0.0451 0.0464 Cash flow for 2006 3 yr Bond in Jan 2007: CF = I * FV + FV when FV = 1 and I = 4.3% = 0.043 Ron Every year Ron invested everything in bonds with maturity of 5 years Katie Money(million) Cash flow for 2006 1 Yr bond Cash flow for 2007 1 Yr bond Cash flow for 2008 1 Yr bond Jan.2006 1 -1 Jan.2007 0.043 -0.043 Jan.2008 0.043 0.0021 -0.0451 Jan.2009 1.135 1.043 0.0451 0.0464 Cash flow for 2006 5 yr Bond in Jan 2007: CF = I * FV + FV when FV = 1 and I = 4.3% = 0.043

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