1. Calculate the Theoretical Fair Value (which is the expected market price) of the following two bonds given the Treasury Spot Curve below:
a. 5 year 3.5% Annual Coupon Treasury Bond
b. 5 year 10.5% Annual Coupon Treasury Bond
r0,1 = 5.00% r0,2 = 5.75% r0,3 = 6.25% r0,4 = 6.65% r0,5 = 7.10%
c. Use the IRR function in Excel to calculate the YTM on each of the two bonds in question #2. Comment on the effect of the Coupon Rate on the YTM and the shape of the spot rate curve.
Use this information for questions d-f below: Assume the spot rates in #1 above are the current market rates. You have just purchased the 5 year 3.5% annual coupon bond in question #1,
d. Calculate the Expected Total Return you would earn if you hold the bond for one year and the market YTM (calculated in #2) one year from now is the same as it is today.
e. Calculate the Expected Total Return you would earn if you hold the bond for one year and the market Spot Rates (as shown in #1) are unchanged next year. (e.g. next year r0,1 = 5.00%, r0,2 = 5.75% …)
f. Explain why the Total Return is greater in #e than in #d