Question #48

of 79 Government spot rate curve is given below: Maturity (years) Rate 1 3.05% 2 4.10% 3 5.25% 4 6.45% The swap fixed rate for a period of 2 years is closest to: A) 4.08% B) 4.75% C) 4.98% Holly Jameson, CFA, has recently started a new role as a bond analyst at her employer, Holt Investment Management, LLC, based in Farland. Her team leader has provided her with up- to-date but incomplete data on the benchmark term structure of interest rates, shown in Exhibit 1. Exhibit 1: Farland Treasury Bond Rates Maturity (years) Spot Forward Par 1 2.30% - 2.30% 2 3.14% 3 4.35% Holly is evaluating a three-year, 6% annual coupon, benchmark bond trading at $108.30. In a discussion in the staff dining room shortly after she joined the firm, Holly's colleague, Doug Ross, made a confident assertion: "I really don't know how some people find bond trading difficult. For each specific maturity, spot rates are always lower than forward rates, and forward rates are always lower than corresponding yield-to-maturity. So you can always achieve a higher return investing in shorter maturity bonds by rolling down the yield curve. I've been doing that since my first day on the job." Holt offers both domestic and international bonds to its clients to enable them to benefit from risk reduction through diversification. She has carried out some preliminary research on the Happyland bond market and has found that the yield curve has an unexpected shape and does not seem to be driven by interest rate expectations. She asks her team leader, Al Smith, for advice, who tells her: "Things are strange in Happyland. Rates are influenced simply by supply and demand of bonds of specific maturities. Different types of investors want particular maturity bonds, and they never seem to deviate from their preferences. High demand for five-year bonds has pushed prices up and yields down." Alex Allan, a bond analyst colleague of Holly, started another discussion with the group by stating: "I'm more interested in what happens to bond prices when the yield curve changes. I need to estimate how much prices will change when short-term yields increase while long-term yields stay constant."