Question

During the class we established the fact that interest rates(discount rates) are negatively affecting the PV. Afterwards, we concluded that if an investor is intersested in getting a certain yield from an investment, she can calculate the fair price for the bond by discounting the future inflows by that yield. If the market price (which will be a proxy for average expected yield) is lower, then the investor will buy the bond. Imagine a scenario of the following investing decision: buy a treasury bond with face value of $1000 and $100 coupons for 30 years that sells for $1280, or a treasury note with similar face value that has 10 years of maturity, issues $70 coupons every year and is selling for $1000.

(a) Calculate the YTM for both using excel. Which one will you pick?

(b) Suppose something happened in between 2nd and 3rd year and now the similar bonds give 10% less yield(i.e. ytm for both is reduced by 10%). Calculate your loss/gain from both investment options.

(c) Consider a scenario where you bought the T-Bond and after the first year the yield for similar bonds is 15% higher. Did you have loss or gain from that? A friend of yours, on the other hand, got the T-Note. How much should the yield of thet T-Note change, in order for your friend to experience similar gain/loss?

Answer 1

Price and yield have an inverse relationship