Low interest rate will not last forever

Quantitative Finance Level 2

If you believe that interest rates will rise soon, which of the following bond trades should you make (to maximize your percentage return)?

Buy a 2 year 10% bond Sell a 2 year zero coupon bond Buy a 2 year zero coupon bond Sell a 2 year 10% bond

1 solution

Calvin Lin Staff
Feb 10, 2015

Since bond prices drop as interest rates increase, you will want to sell a bond.

Furthermore, you will want to sell a bond that has a greater percentage of it's payments that are further out. Hence, you want to sell the 2 year zero coupon bond.

To answer with certainty wouldn't be necessary to know the duration (price sensitivity to interest change) of the zero and the 10% con bond?

A Former Brilliant Member - 5 years, 1 month ago

See my reasoning.

If we wanted to know the exact amount, then yes we have to calculate the duration. However, because we know that duration increases for lower coupons rate, what we want to find is the bond with the lowest coupons (in this simplistic comparison).

If the bond interests were much more varied, then yes further calculation will need to be done.

Calvin Lin Staff - 5 years, 1 month ago

Wouldn't the 2Y 10% bond be worth more than the ZCB ? Therefore selling it would earn more ? Is that why you specify percentage return as opposed to the absolute return?

Marek Vosicky - 3 years, 9 months ago

Note that "selling something that is more expensive" doesn't mean that you "will earn more money". Remember that "Profit = Revenue - Cost", so if the increase in cost is higher than the increase in revenue, then the profit would be lower. In this case, the cost would be the monies used to service of the bond (IE the final payment and any interest payments).

Also, check out macaulay duration of a bond, to understand why the ZCB is more price sensitive to interest rate changes (IE has a higher duration).

Calvin Lin Staff - 3 years, 9 months ago

Low interest rate will not last forever

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