1) Currently, yields to maturity on 1 year and 2 year us treasury securites are
ID: 2722934 • Letter: 1
Question
1) Currently, yields to maturity on 1 year and 2 year us treasury securites are .602% and .852%. You can assume that for simplification purposes there are no coupon payments on these bonds and the yield to maturity is entirely due to the difference in face value and current market price of these securities.
a) If financial market investors were risk neutral, what would this data imply about market expectations of the yield on the 1 year bonds 1 year from now? Show your Calculations.
b) Given that financial market investors are risk averse, do you think actual market expectations differ slightly from your answer to (a). If so, how? Explain your answer.
Explanation / Answer
answer
yeild to maturuty ( FOR 1 YEAR ) =Interest rate+ {(Future price (F) - present price(P)) / no. of year} / (Future price +present price )/ 2
0.602% = 0 + { ( F - P ) / 1} / ( F+P)/2
0.602% = (F-P) / 1 * 2 / (F+P)
0.602 = (F-P) *2 / (F+P)
0.602 (F+P) = 2F - 2P
0.602F + 0.602 P = 2F - 2P
2.602P = 1.398F
F = 1.86 P --------------- equation (1)
yeild to maturuty ( FOR 2 YEAR ) =Interest rate+ {(Future price (F) - present price(P)) / no. of year} / (Future price +present price )/ 2
0.852 = 0 + { ( F - P ) / 2} / ( F+P)/2
0.852 = (F-P) / (F+P)
0.852 F + 0.852 P = F-P
1.852 P = 0.148F
F = 12.51 P -------------- equation (2)
ANSWER A ) The above calculation shows that if the investor is investing in 2 year bond , then he will get 12.51 times of its present investment after two year as per equation no. 2 . But on other hand if he purchase bond after one year then he will get only 1.86 times of the present value. From these two equation it is seems that in the market is expecting the interest rate to rise from the current period which in turn lead to decrease in the price of the bond with 2 year of maturity. As per price - yeild relationship for bonds states that there is a inverse relationship between price of the bond and interest rate prevailing in the market. From equ (2) we have seen that the future value is 12.51 times of the present value but after 1 year it reduces consideraly to 1.86 times of present value that means the interest rate in the market is going up which in turn decreases the market price of the bond.
Therefore, if the financial market investor are risk neutral then the above data imply that the market is expecting the interest rate to rise for 1 year down the line .
Answer 2 . According to condition (a) the market is expecting the interest rate to rise which will be differ slightly from the actual market condition as with the expection of higher interest rate more and more investor park their fund in the bond which in turn lead to fall in the Interest rate in the actual market as demand - supply - price principal state that more and more supply will reduce the price of the product . More and more money chasing for the higher rate of return will ends up with lower interest rate.
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