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CFA Level I · CFA Level I Exam · Interest Rate Risk and Return

An investor buys a three-year, 5% annual-coupon bond at par (100) and plans to sell it after two years. The first coupon is reinvested at 4% for one year, and the bond is sold for 103.00 immediately after the second coupon is received. The annualized horizon yield is closest to:

The horizon yield is about 6.4%. The terminal value is 5.20 from the reinvested first coupon, plus 5 from the second coupon, plus 103 from the sale, giving 113.20. Taking the square root of 1.132 and subtracting one gives 6.39%, which rounds to 6.4%.

  1. A6.3%
  2. B6.4%Correct
  3. C6.6%

Explanation

Future value of the first coupon is 5 × 1.04 = 5.20. Add the second coupon of 5 and the sale price of 103.00 to get 113.20. Horizon yield = (113.20/100)^(1/2) − 1 = 6.39%, or about 6.4%. Ignoring reinvestment income gives 6.30%, and dividing the 13.2% total gain by two gives 6.6%.

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