Question

Currently, the term structure is as follows: One-year bonds yield 11.00%, two-year bonds yield 12.00%, three-year bonds and greater maturity bonds all yield 13.00%. You are choosing between one-, two-, and three-year maturity bonds all paying annual coupons of 12.00%, once a year. You strongly believe that at year-end the yield curve will be flat at 13.00%.

Calculate the one year total rate of return for the three bonds. (Do not round intermediate calculations. Round your answers to 2 decimal places.) One Year Two Years Three Years One year total rate of return %

Answer 1

The total rate of return on bonds involves calculating the coupon payment and the change in price due to changes in the yield curve. As bonds adjust to the expected new yield, their prices will fluctuate, affecting the total return, which includes interest payments and capital gains or losses.

Step-by-step explanation:

The question pertains to the calculation of total rate of return on bonds of different maturities when the yield curve is expected to flatten to a single rate by the end of the year. For each bond, we must take into account its coupon payment and the change in its market price due to the expected shift in interest rates. In this case, because all bonds will be yielding 13% by the end of the year, bonds with a current yield lower than 13% will decrease in price, and those with a yield higher than 13% will increase in price.

The total return for each bond will be calculated using the formula: (Coupon Payment + Change in Price) / Current Price. Here, the 'Change in Price' must reflect the expected price of the bond after the yield curve change. This return includes interest payments and capital gains (or losses) from the bond's price adjustment.