Question

Assume a flat yield curve of 6%. A 3-year $100 bond is issued at par paying an annual coupon of 6%. What is the bond’s expected return if a trader predicts that the yield curve 1 year from today will be a flat 7%?

2.31%

4.19%

6.00%

8.83%

9.21%

Answer 1

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Correct Answer: Option B) 4.19%

Working:

Since the flat yield curve and coupon rate are equal, the bond was issued at the par value which is $ 100.

Now calculate the value of bond at the year-end using,

Discounting rate = predicted flat yield curve= &%

Coupon value = $ 6 as coupon rate is 6 % and face value is 100

Substituting the values

At Year 1 end,

Value of the bond is 6/1.07+106/1.07^2 = 98.19

Now, Also trader receives also $ 6 as coupon amount

Therefore, Total value at the Y1 end is 98.19+6 = 104.19

As the bond was issued at the par value

Return of the trader = (Total Value - Invested Value) / Invested Value

Return of the trader = (104.19 - 100) /100 = 4.19 %

Therefore, Trader's total expected return on the bond is 4.19 %