Question

1. You want to invest a sum of money for two years and have two alternatives:

Alternative 1: 3-year 5% coupon AAA bond selling at a par.

Alternative 2: A AAA bank deposit which pays according to the following rates:

1 year spot rate 4.0%

1 year forward rate one year from now 4.5%

1 year forward rate two years from now 5%

Analyse the alternatives to determine which one is the better deal.

Answer 1

1. Return in AAA Bond = (1 + Interest Rate)^Years -1

Return in AAA Bond = (1 + 0.05)^3 -1

Return in AAA Bond = 1.157625 -1

Return from AAA Bond = 15.76%

2. Return from Bank deposit = (1 + 1 year spot Rate) * (1 + 1 year Forward Rate one year from now ) * ( 1+ 1 year forward rate two years from now) - 1

Return from Bank deposit = (1 + 0.04) * (1 + 0.045) * ( 1+ 0.05) - 1

Return from Bank deposit = 1.1411 - 1

Return from Bank deposit = 14.11%

Alternative One Offers higher return than alternative two. Thus Alternative one is recommended

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