A 40-year maturity bond has a 7% coupon rate, paid annually. It sells today for

Question

A 40-year maturity bond has a 7% coupon rate, paid annually. It sells today for $997.42. A 30-year maturity bond has a 6.5% coupon rate, also paid annually. It sells today for $1,009.5. A bond market analyst forecasts that in five years, 35-year maturity bonds will sell at yields to maturity of 8% and that 25-year maturity bonds will sell at yields of 7.5%. Because the yield curve is upward-sloping, the analyst believes that coupons will be invested in short-term securities at a rate of 6%.

Calculate the annual return for the 40-year maturity bond over the next five years. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Calculate the annual return for the 30-year maturity bond over the next five years. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Calculate the annual return for the 40-year maturity bond over the next five years. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Explanation / Answer

a)   Annual rate of return : 40 years maturity bond:

      Investment:   997.42

     Annual interest: 7 %

     Interest amount : 70/-

     Yield to maturity of 35 years bond 8%

     Coupon reinvestment rate : 6 %

     Present value of 5 yaer Coupon interest discounted @ 6 % = 70* 4.2124   = 295

     Present value of bond in year 5 @ 8 % : 1,000 * .68058   =                           681

     Present value of bond                                                                             = 976

Annual loss in valus (1000 - 976) 5 = 4.8

      Annual rate of return : 70- 4.8/ 997.42    =   6.54%

b)   Annual rate of return : 30 years maturity bond:

      Investment:   : 1,009.50

     Annual interest: 6.5 %

     Interest amount : 65/-

     Yield to maturity of 25 years bond 7.5%

     Coupon reinvestment rate : 6 %

     Present value of 5 yaer Coupon interest discounted @ 6 % = 65* 4.2124   = 274

     Present value of bond in year 5 @ 7.5 % : 1,000 * . =                            697

     Present value of bond                                                                             = 971

Annual loss in valus (1000 - 971) 5 = 5.8

      Annual rate of return : 65 - 5.8/ 1,009.50    =   5.86 %

30 years maturity period: Expected return: 5.86 %

40 years maturity period: Expected return: 6.54 %     

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