Can someone please help me with this question related to reading #20: Yield Curve Strategies
A manager calculates the implied forward rate to exist in one year for today’s 5-year bond to be 5.19%. That same 5-year bond yields 4.85% today and the 1-year bond today yields 3.5%. The manager’s opinion is that interest rates will decrease and that in one year, 4-year bonds will yield 5.0%. Assume for simplicity that all the bonds and interest rates are zero coupon. The return that will be earned on the 5-year bond over the next year if the manager is correct is closest to :
A) 2.75%.
B) 4.25%.
C) 5.00%
Kaplan says the answer is B… But how does a bond with a starting yield of 4.85% and a downward rate move during the horizon period return anything less than 5%?
Thanks for your help.