Question

8. Suppose that you buy a 10-year bond today with 10% pa coupons, payable semi-annually and that the yield curve is currently flat at 10% pa nominal. Suppose that immediately after purchasing the bonds, the yield curve becomes flat at 12% pa nominal. Assuming a face value of $100 and semi-annual compounding and that the bond is held to maturity, what is the annualized holding period yield on the bond?

A. 10.713%

B. 12%

C. 10.66%

D. 11.283%

E.   10%

9. Homer Simpson is considering two investment options. Option 1 involves investing in a zero coupon bond for two years. Option 2 involves investing in a zero coupon bond for one year and then in one year’s time investing in a further one year zero coupon bond. Which of the following are correct?

i.                According to the market segmentation hypothesis, Option 1 would be preferred to Option 2.

ii.              According to the liquidity premium hypothesis, the expected return on Option 1 is lower than the expected return on Option 2.

iii.             According to the pure expectations hypothesis, the expected return from the two strategies, based on information today, is identical.

iv.             According to the preferred habitat theory, Option 1 is preferred to Option 2 but Option 2 may be preferred if it has a sufficiently higher expected return compared to Option 1.

v.               According to the preferred habitat theory, Option 2 is preferred to Option 1 but Option 1 may be preferred if it has a sufficiently higher expected return compared to Option 2.

A. (i) only

B. (ii) only

C. (ii) & (iii)

D. (i) & (iii) & (iv)

E.   (ii) & (iii) & (iv) & (v)

10. Consider a three-year bond with 8% annual coupons and a face value of 100. Assume that the bond is callable and may be called at t=1 with a call price of 101.80. Assume that if the bond is called at t=1, then the investor will invest in a new two year bond with a face value of $101.80 and a coupon rate equal to the market interest rate at t=1. If the market rate of interest at t=1 is 6%, which of the following statements is incorrect?

A. The borrower will call the bond at t=1.

B. The investor will achieve a lower rate of return over the three year investment horizon compared to what would have been achieved if they had initially invested in a three year noncallable bond with 8% annual coupons.

C. If the call price had been initially set below 101.8, the probability of the bond being called would be lower.   

D. The call price is more than the face value because the investor requires some compensation in the event of the bond being called.

E.   If the market interest rate at t=1 is 8%, the borrower will not call the bond.  

11. Suppose the yield curve is as shown below. Assuming semi-annual compounding what is f1,3 ?

1 year spot rate: 4%

2 year spot rate: 6%

3 year spot rate: 8%

4 year spot rate: 10%

A. 10.03%

B. 10.06%

C. 12.06%

D. 12.11%

E.   14.08%

Answer 1

1)	Since the yield changes after the bond has been sold, then the holding period return would not change
	E) 10%
2)	The correct answer is C) ii) & iii) as liquidity premium and expectations hypothesis comes into play
3)	yield to call	9.80%
	yield for new bond at price of 101.8 and coupon of 6%
		5.03%
	Overall yield ((1+0.098)*(1+0.0503)^2)^(1/3)-1	6.60%
	So overall yield of 8% in case of not being called is higher
	Even if the market interest rate is 8% then also the yield by call is 7.93% which is lower than 8%,
	So borrower will still call the bond
	E.   If the market interest rate at t=1 is 8%, the borrower will not call the bond.
4)	F 1,3
	(1+ f1,3/2)^4 * (1+ 4%/2)^2 = (1+8%/2)^6
	F 1,3 =	5.01%