Assume spot rates today are as follow: 6-months 0.75% 12-months 1.00% 18-months

Question

Assume spot rates today are as follow:

6-months         0.75%

12-months       1.00%

18-months       1.25%

24-months       1.50%

(i) Suppose that most investors prefer to hold long-term investments, so the expected return on a series of short-term bonds must be higher than the expected return on a long-term bond in equilibrium.

If the expected price of the bond, which is a 2-year bond that pays a coupon rate of 1.5% (assume semiannual payments - use the convention (1+r/2)t where r is the simple annual interest rate and t refers to the number of semiannual periods) and has a par value of $1,000., six months after it is issued (and just before it makes its first coupon payment), is to be estimated, the answer will be

A. lower than

B. higher than

C. the same as

D. not enough information given to answer

the expected price of this bond 6 months from today, just before it makes its first interest payment.

(ii) In addition to the conditions in the problem i. holds which is short-term bonds have to offer a premium to attract investors. From this information, it is safe to assume that

A. investors in the market expect interest rates to rise

B. investors in the market expect interest rates to fall

C. investors in the market expect interest rates to remain the same

D. impossible to answer

Explanation / Answer

Answer(i)- Lower

Expected return on a series of short-term bonds is lower than the expected return on a long-term bond. Long term bonds are well diversified and provide higher return than the shorter duration bonds. So short term bonds have to provide extra premium to attract investors.

Answer(ii)- Option "A" Investors in the market expect interest rates to rise. As the interest rates rise, price of bond falls and yield on bond increases.

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