Suppose you have a 1-year investment horizon and you are considering three risk-free bonds. All bonds have a face value of £1000 and mature in 10 years. The bonds are priced today such that the (annual) yield to maturity is 5%. The first bond is a zero-coupon bond with a current price of £613.91. The second bond has an annual coupon rate of 5% and a current price of £1000. The third bond has an annual coupon rate of 7% and a current price of £1154.43. Assume that the next coupon payments will be one year from now. 

a)  Suppose you expect that the yield to maturity for each bond will still be 5% at the beginning of next year. What will be the prices of the three bonds one year from now? [Hint: One year from now, the bonds will have 9 more years to maturity.]                                                                                                                            

b)  For each bond, calculate the holding period return (i.e. the net simple return) if you buy the bond today and sell it one year from now (just after collecting the first coupon payment for the coupon bonds).                                            

c) Now suppose you expect that the yield to maturity for each bond will be 4% at the beginning of next year. Recalculate your answers to parts (a) and (b) for each bond. (Note: the current bond prices stay the same.)              

d) Compare the holding period returns in part to the initial yield of 5% and provide a brief intuitive explanation for this result.                              

e)  Take the holding period returns from part where the yield stays constant at 5%. If inflation is 3%, what is the real return on each bond in the first year? Considering this result and the result in part are the bonds really risk-free investments? 

Answer rating: 100% (QA)

SOLUTION a Since the yield to maturity is expected to remain constant at 5 one year from now the prices of the bonds can be calculated using the follo... View the full answer