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Recitation2_Chapter4&amp;TIPS_MB_fa11

# Recitation2_Chapter4&amp;TIPS_MB_fa11 - 3 e What is the...

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Money and Banking (Fall 2011) Recitation #2 on Thursday (9/22) Chapter 4: 1. The yield to maturity (YTM) today can be interpreted as the expected (or average) rate of return if the bond is held until maturity ”. Work through the following example to understand this statement. You buy a coupon bond today ( period t ). It has the following characteristics: Number of years to maturity (n) = 3 F = \$1000 C = \$100 P = \$1000 a) What is the YTM in period t on this bond? b) Let R 1 be the return you would receive if you sold the bond next year ( t+1 ). Assume that there is no change in the interest rate (YTM) between today and next year. What is R 1 ? c) Suppose you bought the bond next year ( t+1 ) and sold it the year after that ( t+2 ). Suppose also that yields have fallen such that the bonds price is \$1100 in period t+2 . What is your return? Denote it R 2 . d) Finally, suppose that you had bought the bond two years from today ( t+2 ) at a price of \$1100 and you held it till maturity. What is your return? Denote it R
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Unformatted text preview: 3 . e) What is the average return? f) How does it compare to the YTM? 2. You bought a newly issued Treasury Inflation Protected Security (TIPS) today at par. It has a real coupon rate of 5% and it matures in five years. The expected inflation rate for the next five years is given below. Complete the table: Year Inflation Nominal Face Value Real Face Value Nominal Coupon Payment Real Coupon Payment 1 1% 2 2% 3-2% 4-2% 5-2% a) At the maturity date, what nominal dollar amount will you receive? What is the “deflation protection” that is built into TIPS? b) Compare this to security to another security that was originally issued 20 years ago. Today, it has 5 years left to maturity. Assume that there was no deflation (only inflation) over the last 15 years. For both the old issued security and the newly issued security to trade, what would need to happen to the yield on the old issued security? Why?...
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