An investor is choosing between 1- 2- and 3-year maturity bonds all paying annual coupons of 8%

QUESTION

Currently, the term structure is as follows: 1-year bonds yield 7%, 2-year bonds yield 8%, 3-year bonds and longer-maturity bonds all yield 9%. An investor is choosing between 1-, 2-, and 3-year maturity bonds all paying annual coupons of 8%, once a year. Which bond should you buy if you strongly believe that at year-end the yield curve will be flat at 9%?
Solution: Let us assume that the face value of the bond is $1,000 for all three categories is $1,000 Annual coupons on the bond = 8% or $80 Current Yield on 1-year bond = Annual Coupon / Current Price = 7%. Hence current price = $80 / .07 = $1,143 Current Yield on 2-year bond = Annual Coupon / Current Price = 8%. Hence current price = $80 / .08= $1,000 Current Yield on 3-year bond = Annual Coupon / Current Price = 9%. Hence current price = $80 / .09= $889 We know that bond yields are inversely proportionate to the bond prices. Also same has been reflected in

he above calculation as well. This means that when the yield are higher, the bond prices are lower. If the year-end yield curve will be flat at 9%, the choice among the three bonds will be in favor of 3-year bond which is at current yield of 9%. This is because in other two categories the year-end yield at 9% will lead to fall in prices as they are available at higher yields.

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