i know this is a daft question and i’m missing something straightforward but could someone please clarify the following? this question is from the cfa curriculum:
Assume a flat yield curve of 6%. A three-year £100 bond is issued at par paying an annual coupon of 6%. What is the bond’s expected return if a trader predicts that the yield curve one year from today will be a flat 7%?
the answer is as follows:
(6 + (6 /1 + 0.07) + (106 /( 1 + 0.07 ) ^2) )100 − 1 ≈ 4.19 %
why isn’t the first cashflow discounted??
thanks
sl
Because it’s 1 year from today; that’s the day you get the first coupon payment.
Not embarrassing at all; your brain’s tired.
As is everyone else’s.
You’re quite welcome.
Sorry. I am still not clear. So are we calculating the return at one year from today and is that the reason the first cash flow is not discounted while the cash flow at end of year 2 is discounted at 7% for 1 year and cash flow at end of year 3 is discounted at 7% for 2 years.
The question states expected return 1 year from now, which will be end of year 1. That’s also when you will receive your first coupon, so no need to discount. If the question asked for expected return today then the first coupon would also need to be discounted. Its a badly worded question by the way… very easy to make an error.