Hi, please help me to understand why 1-year spot rate is being used in the answer to this question instead of the current YTM of the 6-year bond of 3.27%?
The question is as follows:
A bond analyst calculates the implied forward yield in one year for today’s 6-year bond to be 3.27%. That same 6-year bond yields 2.95% today, and the 1-year bond yields 1.50% today. The analyst predicts that interest rates will increase and that in one year, 5-year bonds will yield 3.34%. Assume that all the bonds being evaluated are zero-coupon bonds. If the analyst’s yield prediction is correct, the expected return on the 6-year bond over the next year is closest to:
Answer provided by Schweser:
If the yield on the 6-year bond moves to its implied forward yield of 3.27% in one year’s time (when it becomes a 5-year bond), the return will equal the return on the 1-year bond today (i.e., 1.50%). The analyst forecasts that the yield on the 6-year bond in one year’s time (when it becomes a 5-year bond) will be 3.34%. This is seven basis points higher than the implied forward yield of 3.27%. This higher forecast yield means that the bond’s expected return over the next year will be lower than the return on the 1-year bond today.
Assuming a duration of approximately 5 for the bond in one year’s time:
decrease in return = 5 × 7 bp = 35 bp = 0.35%
expected return over one year = 1.50% − 0.35% = 1.15%
(Study Session 8, Module 20.5, LOS 20.d)