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Hello Mr john, my question is related to Part (a), i have no idea to how the examiner came to the conclusion that the four year yield curve is that of a zero coupon bond and hence to why the fixed rate of 3.7625% is less than the 3.8% four year yield curve rate. Can you explain please ?
its number 62 in BPP exam kit
thxLet me try and explain with an example:
Suppose the yield curve gave 2% for one year, 3% for 2 years and 4% for 3 years.
That would mean that if we invested money now for 1 year we would get 2%.
If we invested money now for 2 years then we would receive at the end of the 2 years a return equivalent to 3% per year (but we would only get a return at the end of the 2 years – not each year).
Similarly, if we invested money now for 3 years we would receive a return equivalent to 4% per year but we would only get it at the end of 3 years (not each year),So….if instead we invested in fixed interest bond, we would get fixed interest every year (not have to wait until the end). So getting fixed interest of somewhere between 2,3,4% would be equivalent.
(but we would only get a return at the end of the 2 years – not each year).- is that an assumption that you have made or is that an assumption for yield curves in general>?
also this is what i understood from what you have wrote , given the yield of a fixed rate bond for 4 years payable each year is 3.7625% ,this is equivalent to the yield of 3.8% for a zero coupon bond payable on the fourth year and since zero coupon bond do not pay interest, this is why the yield on zero coupon is higher.
Is that it?
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