Question

Two-year Government of Canada bonds is currently 4.75% and the yield on five-year Government of Canada bonds is currently 5.5%.

You are a borrower. You have decided that it is highly unlikely that the 3-year rate, two years from today, will rise above 5.50%. Based on this knowledge and the fact that you are a borrower, you should:

Multiple Choice

• Borrow long & lock in the five-year rate today – you will minimize your total interest costs

• Borrow short (2-year) & then roll over into a 3-year loan when the 2-year loan matures – you will minimize your total interest costs

• You are indifferent between borrowing short and rolling over or locking in the long rate initially

Five years ago you invested $10,000 in a mutual fund. You have earned the following annual returns over the last five years: {+18%, -4%, +10%, +22%, -16%}. What is the Geometric Mean of the five annual returns?

Multiple Choice

• 3.67%

• 5.01%

• 6.23%

• 4.33%

Burton Malkiel’s bond theorem #3 said that high coupon bonds have less price volatility than low coupon bonds. Which of the following statements correctly explains why this is true?

Multiple Choice

• High coupon bonds are usually issued by governments

• High coupon bonds are held principally by widows and institutions

• High coupon bonds have a greater proportion of their total cash flow occurring closer to today

• High coupon bonds allow their holders to defer the payment of income tax into the future

Exactly one year ago you bought a three-year, $1,000 bond with an 8% coupon and a 6% yield to maturity (YTM). Just after you bought the bond, the YTM fell to 5%. If you hold the bond to maturity, what rate of return will you actually earn?

A) 6% B) 4.82% C) 5.10% D) 5.93%

Answer 1

1]

Take a 5-year loan

Amount repaid after 5 years (per $1 borrowed) = $1 * (1 + 5.5%)⁵ = $1.307

Rollover loan

Amount repaid after 5 years (per $1 borrowed) = $1 * (1 + 4.75%)² * (1 + 5.5%)³ = $1.288

The correct option is - Borrow short (2-year) & then roll over into a 3-year loan when the 2-year loan matures – you will minimize your total interest costs

2]

Geometric mean is calculated by adding 1 to each year's return, calculating the geometric mean of that series using GEOMEAN function in Excel, and subtracting 1 from the GEOMEAN to calculate the geometric mean.

Geometric mean is 5.01%

3]

The correct option is - High coupon bonds have a greater proportion of their total cash flow occurring closer to today

4]

A - 6%

The bond is bought at a YTM of 6%. The YTM changes after the bond is purchased. As the bond is held till maturity, the rate of return earned is the YTM of 6%.