Question1: You have $1,000 to invest over an investment horizon of three years. The bond market offers various options. You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) a two-year bond followed by a one-year bond. The current yield curve tells you that the one-year, two-year, and three-year yields to maturity are 3.2 percent, 5 percent, and 3.7 percent respectively. You expect that one-year interest rates will be 4 percent next year and 4 percent the year after that. Assuming annual compounding, compute the return on each of the three investments.
Instructions: Enter your responses rounded to the nearest two decimal places.
Expected return for (i) = %
Expected return for (ii) = %
Expected return for (iii) = %
Question2: Tom got a 30 year fully amortizing FRM for $400,000 at 6%, with constant monthly payments. After 3 years of payments rates fall and he can get a 27 year FRM at 5%, but he must pay 2 points and $1500 in closing costs to get the new loan. Think of the refinancing decision as an investment for Tom, he pays a fee now but saves money in the future in the form of lower payments. What is the annualized IRR of monthly payment savings from refinancing for Tom assuming he prepays the new loan 5 years after refinancing?
(Clarification: Tom will prepay the new loan 3+5=8 years after the house is purchased and all costs from refinance are paid in cash at time of refinance)