1.The yield curve… 2. Investment A will return to you $2018 in one year if you i

Question

1.The yield curve…

2.  Investment A will return to you $2018 in one year if you invest $1750 today. Investment B will return to you $3125 in one year. What is the most you will pay for Investment B? Round to the dollar.

3.  According to the yield curve, the one-year rate is 4% and the two-year rate is 10%. A two-year coupon bond pays $50 in one year and $1050 in two years. Calculate the present value of this bond. Round to the penny.

4. If interest rates are expected to fall, how will long-term rates compare against short-term rates?

Explanation / Answer

Solution:

Q1. The yield curve is strongly influenced by the interest rate expectation as bonds are price based on the interest rate.

Q2.

Investment A returns $2018 in one year by investing $1750

So rate of return is = 2018/1750 - 1 = 1.153143 - 1 = 15.3143%

Investment B returns $3125 in one year and we have rate of retun on A = 15.3143%.

So we can discount the $3125 with 15.3143%. to get the maximum amount that can be invested

Maximum invested amount = $2710

Q3.

Payment in 1 year = $50 , yield = 4% ,

Payment in 2nd year = $1050 , yield = 10%

Present Value of the bond = $50/ (1+4%) +  $1050 /(1+10%) = 48.07 + 954.55 = 1002.62

Q4.

Long term interest rate tends to be higher than the short term interest rate, but it is given that interest rate are expected to fall so

Short term and long term interest will be equal

Option C is correct

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