The current term structure of interest rates is given by 1-year spot rate: 1%, 2-year spot rate:…

The current term structure of interest rates is given by 1-year spot rate: 1%, 2-year spot rate: 1.5% and 3-year spot rate: 2%. Suppose that there are 1-year, 2-year and 3-year bonds with coupon rates equal to 2% with annual coupon payments. You strongly believe that after one year the spot rate curve will become flat, but you are not sure how much will be the future level of interest rates. Your current guess is as follows. Interest rates will go up to 3% with the probability of 40%, will become 2% with the probability of 50%, and will go down to 1% with the probability of 10%. (a) Compute the one-year holding-period return on each bond purchased now and sold after one year under each of these three interest rate scenarios. Hint: The one-year holding period return on a bond is the rate of return on purchasing it now and selling it after one year. That is, it can be computed by the following expression. one – year holding – period return = PV’-PV PV where PV is the current present value of the bond and PV’ is the present value of it after one year. (b) Which bond can you expect to realize the highest return based on the above probabilities of each scenario?

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