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Homework 3

This document contains examples and calculations related to bond yields and interest rates over multiple time periods. It discusses the expectations theory and how bond yields can be estimated from short term interest rates. It also provides an example of calculating term premium by comparing long term bond yields to estimated yields from short term investments.

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adnan
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38 views

Homework 3

This document contains examples and calculations related to bond yields and interest rates over multiple time periods. It discusses the expectations theory and how bond yields can be estimated from short term interest rates. It also provides an example of calculating term premium by comparing long term bond yields to estimated yields from short term investments.

Uploaded by

adnan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Adnan bin Ibrahim bin hameed

(219526870)

ECON3076A

Money and Financial markets

Homework-3

23 Nov 2022
1.

If $1000 is invested in a two-year bond today, the amount received after two years = $1000 * (1
+ 8%) * (1 + 8%) = $1166.40

i]

If $1000 is invested today, the amount received after two years = $1000 * (1 + 7%) * (1 + 9%) =
$1166.30

ii]

If $1000 is invested today, the amount received after two years = $1000 * (1 + 5%) * (1 + 11%)
= $1165.50

iii]

If $1000 is invested today, the amount received after two years = $1000 * (1 + 3%) * (1 + 13%)
= $1163.90

iv]

If $1000 is invested today, the amount received after two years = $1000 * (1 + 0%) * (1 + 16%)
= $1160.00

b.

From the results these values are very near from the data given the future value of the two year
bond is $1166.4 and by the question one at the frequent year's future value is $1166.3 those are
very near. And at second year the future value at frequent years $1165.5 it is also a very near
And at third one the frequent year value is $1163 it has some difference but it is not bad and a
the Fourth year the frequent year value is $1160 it has some difference but it is also not bad by
these results it is a good process to take the decision this assumption is very use full to the
investor to Make decision

2.

According to expectations theory investor earns the same amount of interest by investing in two
consecutive one-year bonds versus investing in one two-year bond today. Therefore based on this
principle

Expected interest rate on 2 year bond today = [(1+ interest rate on 1 year bond today)*(1+interest
on 1 year bond 1 year from now)]^(0.5) -1

=> [(1.05)*(1.07)]^(0.5) -1 => 5.99% or 6%


3.

Option A Option B
One Year bond interest One Year bond interest one year from Combined 2 year
Calculation
today now interest
(1.01*1.08)^0.5-
1.000% 8.000% 4.44
1
(1.02*1.06)^0.5-
2.000% 6.000% 3.981%
1
(1.03*1.05)^0.5-
3.000% 5.000% 3.995%
1
(1.05*1.03)^0.5-
5.000% 3.000% 3.995%
1

4.

Let's Say we have $100 today

If he invests in a 4 year bond today,

interest on 4 year bond = 6.2%

value after 4 years = 100 * (1+.062)^(4) = $127.20

If he invests in 3 year bonds and after 3 years in a 1 year bond,

3 year bond yield = 5.8% and 1 year bond yield 3 years from now = 8%

Value after 4 years = 100*((1+.058)^(3))*(1+.08) = $127.90

If he invests in 2 year bonds and after 2 years in a 1 year bond and after 3 years in a 1 year bond,

2 year bond yield = 5.4%

1 year bond yield 2 years from now = 7%

and 1 year bond yield 3 years from now = 8%

Value after 4 years = 100*((1+.054)^(2))*(1+.07)*(1+.08) = $128.38

If he invests in 1 year bonds each year for the next 4 years

1 year bond yield now = 5%


1 year bond yield 1 year from now = 6%

1 year bond yield 2 years from now = 7%

and 1 year bond yield 3 years from now = 8%

Value after 4 years = 100*(1+.05)*(1+.06) *(1+.07)+(1+.08) = $128.62

So sequence of options basis the value after 4 years,

Investing in 1 year bond

investing in 2 year bond

investing in 3 year bond

investing in 4 year bond respectively

5.

a) Based on expectation theory

(1+ 0i2)^2 = (1 + 2%) x (1 +3%)

=> 0i2 = 2.50%

Similarly, (1 + 0i3)^3 = (1 + 2%) x (1 +3%) x (1 + 4%)

=> 0i3 = 3.00%

b) Interest rate on two-year bond = 2.50% + 0.75 x 2 = 4.00%

Interest rate on three-year bond = 3.00% + 0.75 x 3 = 5.25%

6.

Rate of Interest for 2 year bond without term premium = [ (1.03)*(1.035)


]^(1/2) -1
= 0.0325
= 3.25%

Rate of Interest for 2 year bond with term premium = 3.25% + (2*0.75)
= 4.75%

7.

The term premium is the difference between the long term maturity bond and the average risk
free bonds rate during that maturity period. It is a reward for holders of the long term bond for
choosing higher maturity bond over a series of short term bonds.

2 years bond Yield = 7%

2 years bond Yield if made through short term yearly investments = 7% - 0.5% = 6.5%

Let 1 year bond yield rate at end of 1st year be Y

So,

[1/(1+0.065)][1/(1+0.065)] = [1/(1+0.05)][1/(1+Y)]

(1.05)(1+Y) = (1.065)(1.065)

1+Y = 1.0802

Y = 0.0802 or 8.02%

3 years bond Yield rate if mads through short term bonds = 7.5% - 1% = 6.5%

Let one year bond rate at end of 2nd year is Z

(1.065)(1.065)(1.065) = (1.05)(1.0802)(1+Z)

1+Z = 1.065

Z = 0.065 or 6.5%

So, 1 year bond rate at end of first year is 8.02%

1 year bond rate at end of second year is 6.5%

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