Question

Currently, the term structure is as follows: One-year bonds yield 7%, two-year bonds yield 8%, three-year bonds and greater maturity bonds all yield 9%. You are choosing between one-, two-, and three-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%?

Short answer

Answer

Three year maturity bond

Step-by-step solution

Step by Step Solution Step 1: Calculation of holding period return

Explanation on choice between one year, two year and three year bond

From the table above, it is apparent that the three year bond would give 9% holding period return which is the highest amongst all. Hence one should buy this.