Multiple choice: Which one is correct? You have $1,000 to invest over an investm

Question

Multiple choice:

Which one is correct?

You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) a two-year bond followed by a one-year bond. The current yield curve tells you that the one-year, two-year, and three-year yields to maturity are 3.5 percent, 4.0 percent, and 4.5 percent respectively. You expect that one-year interest rates will be 4 percent next year and 5 percent the year after that. Assuming annual compounding, compute the return on each of the three investments. Expected return for (i) Expected return for (i) Expected return for (i)

Explanation / Answer

Expected return for (i) = (1.035)*(1.04)*(1.05) – 1 = 13.02%

Expected return for (ii) = (1.045)3-1 = 14.12%

Expected return for (iii) = (1.04)2*(1.05) – 1 = 13.57%

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