Consider the following 4 securities *12-year maturity *12-year maturity zero-cou

Question

Consider the following 4 securities *12-year maturity *12-year maturity zero-coupon bonds issued by company AAA 10-year maturity 12%-coupon bonds issued by AAA: 7-year maturity 8%-coupon bonds issued by AAA; *1-year maturity commercial paper issued by AAA As a portfolio manager for an insurance company, you are about to invest S10 Billion in one of these securities. You plan to maintain your investments for exactly one year (no more, no less). You anticipate that U.S. economic growth will increase substantially over the next year, while most other investors expect economic growth to be flat during the next year Assuming your expectations about the economy are correct, how well will each of these 4 investments perform over the next year relative to each other?

Explanation / Answer

Since the expectation for the economy is that growth will increase significantly over next year, therefore inflation may increase due to high growth. To curtail inflation, Federal Reserve may try to increase interest rates. In period of rising interest rates, bonds with low coupon or high maturity or both will fall in their price and therfoe it may lead to high capital loss in our bond investment. Therefore portfolio manager should choose a bond with low maturity and high coupon.

Since all bonds are AAA rated, there is no question of credit risk or atleast they are equal.

Also the investment horizon is only a year.

We can also use a measure called duration to examine the price sensitivity of a bond, Higher the duration, Higher the price sensitivity of a bond. Duration is higher for bonds with low coupon or high maturity or both and vice versa. Therefore bonds with high duration will loss more than the one with low duration when interest rates are rising.

Apart from all these explanation, 1 year commercial paper can be redeemed exactly after on year and therefore there wont be any loss even if interest rate rises.

Therefore the portfolio manager should chose 1 year maturity commercial paper issued by AAA.

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