Question

Noah Kramer, a fixed-income portfolio manager based in the country of Sevista, is considering the purchase of a Sevista government bond. Kramer decides to evaluate two strategies for implementing his investment in Sevista bonds.

Table 11.6 gives the details of the two strategies, and Table 11.7 contains the assumptions that apply to both strategies.

Before choosing one of the two bond investment strategies, Kramer wants to analyze how the market value of the bonds will change if an instantaneous interest rate shift occurs immediately after his investment.

The details of the interest rate shift are shown in Table 11.8. Calculate, for the instantaneous interest rate shift shown in Table 11.8, the percent change in the market value of the bonds that will occur under each strategy.

Short answer

Strategy 2:

Step-by-step solution

Given information

D= 4.83 years (5-year maturity)

D= 14.35 years (15 years maturity)

Formula = ∆P/P = −D x ∆y

Comparison of two strategies

Strategy 1:

∆P/P = −4.83 × (−0.75%) = 3.6225% (5 year maturity)

∆P/P = −23.81 × 0.50% = −11.9050% (15 year maturity)

Strategy I: ∆P/P = (0.5 × 3.6225%) + [0.5 × (−11.9050%)] = −4.1413%

Strategy 2

∆P/P = −14.35 × 0.25% = −3.5875% (15-year maturity)