An investor's investment time horizon is two years. Spot rates for on-the-run annual-coupon government securities and swap
Question:
An investor's investment time horizon is two years. Spot rates for on-the-run annual-coupon government securities and swap spreads are shown as:
Maturity (years)1234
Government spot rate0.5%1.0%1.25%1.5%
Swap spread0.25%0.30%0.5%0.65%
The investor believes that interest rates will remain stable and the yield curve will not change its level or shape for the next two years. Swap spreads will also remain unchanged. The investor is considering 3 possible investments as follows. (Assume annual coupon payments throughout.)
(1) Employ a "riding the yield curve" strategy by buying a high quality four-year, zero-coupon corporate bond and then selling it after two years when yield would be lower. Assume the swap rate proxies for this corporate bond yield. What would be the annualized return over this horizon?
(2) Buy an off-the-run1.6% government bond with two years to maturity.
(3) Buy a lower-quality, two-year 3% coupon corporate bond with a Z-spread of 200bpswith inside information that the bond is most unlikely to default in the next 3 years.
What are the annualized returns of the 3 possible investments, and which will fetch the highest return?
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