Question

The following yield data relates to a number of high-quality corporate bonds recorded at each of the three points in time:

	Yield to Maturity
Maturity (years)	5 years ago	2 years ago	Today
1	9.08%	14.5%	9.38%
3	9.23%	12.83%	9.84%
5	9.28%	12.19%	10.94%
10	9.51%	10.86%	12.64%

Required: Consider the data from 5 years ago. According to the expectations hypothesis, what approximate return did investors expect a 5-year bond to pay as of today? Hint: think of expectations as a percentage difference in returns between the present and the future.

Answer 1

Expectation Hypothesis states that "the current price of an asset is equal to sum of expected discounted future dividends/coupon payment conditional on the present Information."

In our case, 5 years back, the return expected by by the bond holder on 5 year bond will be the "Yield to maturity of 5 year bond, componded at YTM rate for 5 years."

Considering the data from 5 years back, the Yield to maturity of the 5 year bond is 9.28%.

Thus, as per expectation Hypothesis, the return expected today will be computed as under

Expected return today (5 years back)    = (YTM 5 years back) * ( 1 + YTM 5 years back)5

= 9.28% * (1 + 0.0928)5

Expected return today (5 years back) = 14.46 % (approx)