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As a portfolio manager for an insurance company, you are about to invest funds in one of three possible investments: a) 10-year coupon bonds issued by the U.S. Treasury, b) 20-year zero-coupon bonds issued by the Treasury, or c)One-year Treasury securities. Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon will be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly.

a. If your expectations are correct, how will the return of each investment be affected over the one-year horizon?

b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon and why?

C. Offer possible reasons you might not select the investment that would have the highest expected return over the one-year investment horizon.

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Elin Hessel
Elin HesselLv2
29 Sep 2019

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Each possible investment is perceived to have no risk of default. You plan to maintain this investment for a one-year period. The return of each investment over a one-year horizon will be about the same if interest rates do not change over the next year. However, you anticipate that the U.S. inflation rate will decline substantially over the next year, while most of the other portfolio managers in the United States expect inflation to increase slightly. a. If your expectations are correct, how will the return of each investment be affected over the one-year horizon? b. If your expectations are correct, which of the three investments should have the highest return over the one-year horizon and why? Offer possible reasons you might not select the investment that would have the highest expected return over the one-year investment horizon.

Suppose the current one-month futures price for a 2-year U.S. Treasury note is 99.77 (percent of par) with a yield of about 1% and the current one-month futures price for a 10-year U.S. Treasury note is 95.17 with a yield of about 3.7%. The 2-year note underlying the futures contract (the cheapest-to-deliver) has a coupon of 1% and pays interest semi-annually. The 10-year note underlying the futures contract has a coupon payment of 3.125 paid semi-annually. You are convinced that the yield curve will continue to steepen over the next one month horizon, so that the difference in yields between the 2-year and the 10-year will be three full percentage points in one month. What futures spread trade do you want to execute (i.e. which instrument do you want to be short and which instrument do you want to be long)? Demonstrate that the trade works (i.e., you make money) if your expectations about interest rates is correct. You are long ____________________ You are short ____________________

Inflation is expected to be 3 percent over the next year. You desire an annual real rate of return of 2.5 percent on your investments.

a. What nominal rate of interest would have to be offered on a one-year Treasury security for you to consider making an investment?

b. A one-year corporate debt security is being offered at 2 percentage points over the one-year Treasury security rate that meets your requirement in (a). What would be the nominal interest rate on the corporate security?

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