Question

Suppose the current yield on a​ one-year zero-coupon bond is 2 % ​, while the yield on a​ five-year zero-coupon bond is 4 % . Neither bond has any risk of default. Suppose you plan to invest for one year. You will earn more over the year by investing in the​ five-year bond as long as its yield does not rise above what​ level? ​ (Assume $ 1 face value​ bond.)  ​Hint: It is best not to round intermediate calculations​ - make sure to carry at least four decimal places in intermediate calculations. Note​: Assume annual compounding.

Answer 1

Answer :

Yield on one-year zero-coupon bond = 2 % ​

Yield on a​ five-year zero-coupon bond = 4 %

Let the initial price of bond = Po and selling price after 1 year = P1

The return on investment will be

So, on a five year zero-coupon bond the initial price will be:

Selling price after 1 year will be :

The break - Even Yield will be :

r = 0.0450 = 4.5%

So, You will earn more over the year by investing in the​ five-year bond as long as its yield does not rise above 4.5%