QUESTION-3:[151 Suppose that you have $1000 to invest in the bond market on Janu

Question

QUESTION-3:[151 Suppose that you have $1000 to invest in the bond market on January 1,2017. You could buy a one-year bond with an interest rate of 4%, a two-year bond with an interest 5%, a three-year bond with an interest rate of 5.5%, or a four-year bond with an interest rate of 6%. You expect interest rates on one-year bonds in the future to be 6.5% on January 1, 2018, 7% on January 1 , 2019, and 9% on January 1,2020. You want to hold your investment until January 1, 2021.Which of the following investment alternatives gives you the highest return by 2021 (a) buy a four-year bond on January 1,2017 (b) buy a three-year bond January 1, 2017, and a one-year bond January 1, 2020, (c) buy a two-year bond January 1, 2017, a one-year bond January 1, 2019, and another one-year bond January 1, 2020, or (d) buy one-year bond January 1, 2017, and then additional one-year bonds on the first days of 2018, 2019, 2020?

Explanation / Answer

Assuming all are zero coupon bonds

FV = PV*(1+r)n

a) buy a 4 year bond

FV = 10000*(1+6%)4 = 12624.77

b) buy a 3 year bond and then 1 year bond

FV = 10000*(1+5.5%)3 *(1+9%)= 12799.23

c) buy a 2 year bond and then 1 year bond then 1 year bond

FV = 10000*(1+5%)2 * (1+7%) * (1+9%)= 12858.46

d) buy a 1 year bond each year

FV = 10000*(1+4%) * (1+6.5%) * (1+7%) * (1+9%)= 12917.94

Option D gives highest return

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