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Midterm exam preparation

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1. Which bond would produce a greater return if the pure expectations theory was to hold true, a 2-year bond with an interest rate of 13% or two 1 year bonds with sequential interest payment of 13% and 18%?

Return from two 1 year bonds with sequential interest payment of 13% and 18% is = (13+18)/2=15.5 is higher then two year rate of 13%

2. You observe the following market interest rates, for both borrowing and lending:

one-year rate ’ 5.5%

two-year rate ’ 6%

one-year rate one year from now ’ 7%

How can you take advantage of these rates to earn a riskless profit? Assume that the Pure Expectation Theory for interest rates holds.

2 y rate = (5.5 +7)/2=6.25% is higher then 6%

So, borrow at 6% at two year rate and lend at 5.5% first year and at 7% second year

3. What is the yield on a $1,000,000 municipal bond with a coupon rate of 7%, paying interest annually, versus the yield of a $1,000,000 corporate bond with a coupon rate of 10% paying interest annually? Assume that you are in the 25% tax bracket

Yield MB =7%

Yield CB = 10% x (1-0.25)=7.5%

4. Calculate rate of return for the 9% 5 year coupon bond with a face value $1000 and YTM is 7% if you are going to sell the bond next year when interest rate is 9%.

PV (buy) = 1082

PV (sell) = 1000

Rate of return= (1000-1082+90)/1082=0.74%

5. You own a $1,000-par zero-coupon bond that has 5 years of remaining maturity. You plan on selling the bond in one year and believe that the required yield next year will have the following probability distribution:

|Probability |Price |Required Yield |

|0.3 | |6.60% |

|0.4 | |6.75% |

|0.3 | |7.45% |

a. What is your expected price when you sell the bond? 749.65

b....