Question

2. You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) a two-year bond followed by a one-year bond. The current yield curve tells you that the one-year, two-year, and three-year yields to maturity are 3.5 percent, 4.0 percent, and 4.5 percent respectively. You expect that one-year interest rates will be 4 percent next year and 5 percent the year after that. Assuming annual compounding, compute the return on each of the three investments, and discuss which one you would choose.

Answer 1

Expected return for investment (i) is 13.02%

Expected return for investment (ii) is 14.12%

Expected return for investment (iii) is 13.57%

Explanation:

We can compute the return on three investments by proceeding as shown below:

Expected return for investment (i) = (1+3.5%) x (1+4%) x (1+5%) - 1

                                                         = (1.035*1.04*1.05) -1

                                                         = 13.02%

Expected return for investment (ii) = (1+4.5%)³ -1

                                                         = (1.045)³ - 1

                                                         = 14.12%

Expected return for investment (iii) = (1+4%)² x (1+5%) - 1

                                                          = (1.04)² x (1.05) - 1

                                                          = 13.57%