Chapter 11, Problem 27PS

Summary Introduction

To Discuss:

Currently, the term structure is as follows:One-year bonds yield 7%, two-year zero-coupon bonds yield 8%, three year and longer maturity zero coupon bonds all yield 9%.You are choosing one,two and three year maturity bonds all paying annual coupons 0f 8%.The bond which will provide the highest rate of return if at year end the yield curve will be flat at 9%,is to be determined.

Introduction:

A bond is a security that creates an obligation on the issuer to make specified payments to the holder for a given period of time. The face value of the bond is the amount the holder will receive on maturity along with the coupon rate which is also known as the interest rate of the bond.A zero-coupon bond is a bond where the face value is repaid at the time of maturity.

Yield to maturity means the discount rate which makes the present payments from the bond equal to the price, in simple terms it is the average rate of return a holder can expect from that bond.