Reading 16 here, capital market expectations, practice problem 6B, question asks for which is better (based on the supplied table): - buying a 6 month security now and then another one in 6 months - buying a 1 month security and rolling that security each month at the prevailing yield for 1 year. The answer says that the 6 month security gives superior results, but why is there no calculations given?
no calculation needed. (unless they state show calculations).
buy and roll - would involve - sell securities, buy new ones - and for both legs you would have transaction costs.
doing that process more often is a drag on your portfolio.
1 B + 11 S/B = 23 transaction costs
For a 6 month = 1 B + 1 S/B = 3 Transaction costs
so a bigger drag due to the 1 Month rolling process.
The solution mentions nothing of transaction costs though… I think we’re meant to assume they are 0 for this problem, and just look at the return apart from that. My best attempt at understanding it, and I could be wrong is this:
inverted yield curve means that 1 month rate is currently better than 6 month rate. However, the expectation is that every month, rates are going to get a little bit lower. So even though you’ve got a 1 month rate of 4.98% available now, and only 4.58% for the 6 month rate, a 1 month rollover means you’ll be rolling into a worse rate every month, so that by month 5, maybe 1 month rates are only like 3 % or something like that, and looking to drop further. The solution also discusses the duration, and says “the bond portfolio will be profitable when the yield curve subsequently flattens or inverts”. I take that to mean that at some point down the line, there will be a bottom to interest rates, and then they’ll start coming back up. In the meantime, by extending your duration, you hold a rate that is, overall, higher than that bottom. When rates start going back up, you’ll want to shorten your duration and rollover more frequently.
Of course, I could be wrong and the the real answer is something else.
I see we are told the yield curve over the year will flatten or inverts, therefore its best to lock in a high yield now than roll every month when the yield curve will subsequently flattens or inverts. Hence a 6 month security gives superior results than a 1 month security rolled every month.
I think both of you are correct. Even if i nothing is mentioned as regards the Transaction cost, why SHOULD NOT we assume that Transaction cost increases with the no. of times the investment is rolled over? It is only logical.
Further,since it is already stated about the yield curve shape, it makes sense to lock in now for 6 months rather than roll over every month(with extra transaction costs as well) only to get lower yield each month.