A recent survey revealed that the market expects the 1-year interest rate to be

Question

A recent survey revealed that the market expects the 1-year interest rate to be 5% one year from now, down from itís current level of 6%: If these expectations are correct: 3. What should be the current yield on a 2-year bond: (a) 5.5%; (b) 5%; (c) 6%; (d) 7%; 4. What is the expected capital gain (+) or loss (-) on a $100 dollar face value 2-year bond: (a) -2.00; (b) -0.50; (c) 6.00; (d) 0.50; 5. What is the holding period yield on the two-year bond assuming it has a face value of $100: (a) 2%; (b) 5%; (c) 6%; (d) 9%;

Explanation / Answer

3. Current Yield on 2 year bond = [1.06 * 1.05 ]1/2 = 1.055 i.e. 5.5 %

4. Expected Capital gain = -0.5

5. Current Yield is good approximation of holding period yield. Therefore holding period yield yield on two year bond = 6%.

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