Reference no: EM132937795

Question - A. Sharon is a thirty-two-year-old solicitor for large firm on a very good income. Apart from a reasonable mortgage on her flat in Saint Johns' Wood London, she has few if any financial responsibilities. She is wondering how to invest her annual bonuses and prefers bonds to equities.

B. Keith is a fifty-eight-year-old soon-to-be retired dentist. He has paid-off his mortgage and his children are independent. He is a widower. He is hoping to sell his dental practise to the new junior colleague for approximately £300K. He is wondering how to invest the windfall and prefers bonds to equities.

As background, you may assume the following: It is the beginning of January, 2021. The rate of inflation is expected to be 2% throughout this year. But increased government deficits and a stronger economy are expected to push the rate of inflation higher. According to the Bank of England, the inflation rate is expected to be 3% in 2022 and 4% in 2023 and 5% in 2024 and continue at this rate thereafter. The real rate of interest on Government Treasury bonds is 2% and not expected to change. The maturity premium grows by 10% per annum. So, for example, as the Treasury rate is 2% in 2021, it is expected to be 2.2% in 2022, excluding the inflation premium. One Year Treasury Bonds are paying therefore 4%- and Two-Year Bonds, 5.2%. AA Corporate Bonds have a credit spread of 150 basis points, so for example, if Treasury Bonds are paying 4% in 2021, then AA Bonds have a Yield of 5.5% and 6.7% in 2022.

Required - What is the Yield on the above bond, given the return and the Coupon offered? [Hint: the formula in Excel for bond pricing might be useful.] Explain your results. What would happen to the Yield if the Prevailing interest rate as shown on the Yield Curve were to fall?