As a portfolio manager for an insurance company, you are about to invest funds i

Question

As a portfolio manager for an insurance company, you are about to invest funds in one of three possible investments: a) 10-year coupon bonds issued by the U.S. Treasury, b) 20-year zero-coupon bonds issued by the Treasury, or c)One-year Treasury securities. Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon will be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly.

a. If your expectations are correct, how will the return of each investment be affected over the one-year horizon?

b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon and why?

C. Offer possible reasons you might not select the investment that would have the highest expected return over the one-year investment horizon.

Explanation / Answer

a. We know both inflation rate and interest rates go hand in hand. If inflation rates decline, it is the most likely that interest rates will also decline. Interest rates and prices share inverse relationship. Hence, As a result of decrease in the interest rates, the prices of all bonds will increase.

b.We know longer the maturity higher would be the change in prices as a result of change in interest rates. Here, the portfolio manager is expecting a decline in interest rates; it will cause the prices to increase for all three bonds. But the Price for 20 year zero coupon bond will change the most as it has the highest maturity. Therefore, the zero coupon bond with 20 years of maturity will have the highest amount of return in one year.

c. Expectations are made about the future and that can go wrong. If portfolio manager’s expectations go wrong and interest rates increase, then the value of each bond will decline. The value of 20 year zero coupon bond will decrease the most as it has the highest period of maturity. Therefore, this bond will have the lowest return and the portfolio manager may have to repent on his decision.

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