Question

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; or (ii) a three-year bond; The current yield curve tells you that the one-year, two-year, and three-year yields to maturity are 3 percent, 4 percent, and 4.4 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 two investments.

Expected return for (i)=

Expected return for (ii)=

Answer 1

The computation of the return on each of the two investment is shown below:

a. Expected return for (i) is

= (1 + 1 Year maturity yield)*(1 + 1 year Interest Rate for coming Year) * (1+ 1 year Interest Rate After coming Year) - 1

= (1+3%)*(1+4%)*(1+5%) - 1

= 12.48%

b. The expected return for (ii) is

= (1+ 3 Year maturity yield)^3 - 1

= (1 + 4.4%)^3 - 1

= 13.79%