Assume you purchased a 20-year 4% coupon bond with semiannual coupon payments when the YTM was 6%.
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Question:
Assume you purchased a 20-year 4% coupon bond with semiannual coupon payments when the YTM was 6%. One day after purchasing the bond, the interest rate dropped by 1% and there would be no further interest rate change for the next 20 years. All coupon income will be reinvested at the prevailing interest rate.
- If you plan to hold this bond to its maturity, what will be your expected rate of return?
- If you want to lock-in the 6% yield, what is your planned investment horizon? (Show your work/calculation of the rate of return from this investment horizon).
- Assume you have a lump sum liability due in 15 years. The interest rate on that liability is 5.2%. You are forming an immunized portfolio now to match that liability. You are considering using a 20-year 4% coupon Treasury bond (with semiannual coupon payments) currently selling at 6% YTM and a high-grade preferred stock currently paying 6% dividend yield to form that immunized portfolio. How will you allocate the bond and the preferred stock in the immunized portfolio?
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