03 Jun Assignment (This assignment accounts for 25% of your total marks to pass this course)
Question
Assignment
(This assignment accounts for 25% of your total marks to pass this course)
TOTAL: ________/38 marks
1|Page
QUESTION 1 (10 marks)
On September 1, 2012, Al buys a bond for $15,000 that makes coupon payments of $750 after each of the
following three years and returns its principal of $15,000 at the end of the three years. In other words, it is
a standard coupon bond with a 5 percent annual interest rate making payments once each year.
On September 1, 2013, Al receives his first coupon payment of $750. At that time, the market interest rate
on bonds like Al’s has risen to 6 percent. Al sells his bond to Biff at that time, for a price equal to the present
value of the bond’s payments.
a. How much does Biff pay Al for the bond?
b. Calculate Al’s current yield, capital-gains yield, and total return for the year.
On September 1, 2014, Biff receives a coupon payment of $750. The market interest rate on bonds like his
remains 6 percent. Biff sells his bond to Cass at that time, for a price equal to the present value of the bond’s
payments.
c. How much does Cass pay Biff for the bond?
d. Calculate Biff’s current yield, capital-gains yield, and total return for the year.
On September 1, 2015, Cass receives a coupon payment of $750 and the principal of $15,000. Over the
course of the year (between September 1, 2014, and September 1, 2015), the market interest rate on bonds like his rose to 7 percent. But Cass decided to keep the bond.
e. What is Cass’s total return for the year?
Explain and show all your work for each part.
QUESTION 2 (6 marks)
Consider the bond market to be in equilibrium according to our complete theory of the term structure of
interest rates. The current interest rate on one-year bonds is 2 percent, and you believe, as does everyone in the market, that in one year the interest rate on one-year bonds will be 3 percent, and in two years, the
interest rate on one-year bonds will be 4 percent. That is, using our standard notation,
= 2%, = 3%, and = 4%.
Assume that there is no term premium on a one-year bond.
a. According to the expectations theory of the term structure of interest rates, what will the
interest rate be today on a two-year bond and a three-year bond? That is, what is and
Suppose the term premium equals 0.75 percent the number of years to maturity, for the 2-year bond and
the 3-year bond.
b. Calculate the interest rate today on the two-year bond and the three-year bond, incorporating
the term premium.
c. Draw the yield curve for today, using the values you calculated in part b. Your drawing
should show three points and should be drawn reasonably to scale, showing the values
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