PLEASE SHOW ALL WORK AND FORMULAS. PLEASE NO EXCEL The yield-to-maturity for a z

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PLEASE SHOW ALL WORK AND FORMULAS. PLEASE NO EXCEL

The yield-to-maturity for a zero coupon bond is 6.70% for a 1-year bond, 7.30% for a 2- year bond, and 7.74% for a 3-year bond. You think the yield curve will remain the same throughout the future. You wish to make a 1-year investment, that is, buy a bond today and sell it in one year. You can pursue three alternative strategies, call them S1, S2, and S3. For strategy S1, you buy the 1-year bond and hold it to maturity, in which case your annual rate of return obviously is 6.70%. For S2, buy a 2-year bond today and sell it when it has 1 year remaining to maturity. For S3, buy a 3-year bond today and sell it when it has 2 years remaining to maturity. What are your average annual rates of return for strategies S2 and S3? (Assume, if necessary, that you can buy fractions of bonds.) a. Strategy S2 earns 10.45% and strategy S3 earns 8.62% b. Strategy S2 earns 10.45% and strategy S3 earns 7.50% C. Strategy S2 earns 7.90% and strategy S3 earns 8.62% d. Strategy S2 earns 7.90% and strategy S3 earns 7.50% e. Strategy S2 earns 9.09% and strategy S3 earns 7.50% 2 9 9 2

Explanation / Answer

The return for strategy S2 can be calculated as:

Buying price = 1000/(1.073^2) = 868.56

Selling price after 1 year = 1000/(1.067) = 937.2

So, return = (937.2-868.56)/868.56

= 7.90%

Strategy S3:

Buying price = 1000/(1.0774^3) = 799.59

Selling price after 1 year = 1000/(1.073^2) = 868.56

So, return = (868.56-799.59)/799.59

= 8.62%

Hence option C is correct

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