Problem
You are working as a wealth manager and are presented with two investment options. The current risk-free rate is 2.5%.
Option I is a 8.000.000 ISK bond that matures in 7 years and pays a coupon rate of 3.5% with annual payments. Since the bond is considered relatively short it has a maturity premium of 1%. The issuer is a company with a credit risk rating BBB so the credit risk premium is 3%. Inflation is expected to be low for the forecasted period so the inflation premium is only 2%.
Option II is a 4.000.000 ISK bond that matures in 5 years. This bond has a different structure. It has variable coupon rates:
Year 1: 1%
Year 2: 1.5%
Year 3: 2.5%
Year 4: 3%
Year 5: 3.5%
Option two has a maturity premium of 0.5% and an inflation premium of 2%. This company has a good credit rating of AAA so the credit risk premium is only 1%.
1. Your job is to find the price that an investor would be willing to pay for the bonds.
2. Your boss is more inclined to invest in option 1 as he prefers longer bonds. Before he does that he wants to make sure that the bond isn't to sensitive to interest rate changes. He wants to know what happens if interest rates increase/decrease by 2%. If the duration is more than 5 he does not want to invest. You are working as a wealth manager and are presented with two investment options. The current risk-free rate is 2.5%.