Q. Based on Exhibit 2 and the anticipated effects of the monetary policy change, the expected annual return over a three-year investment horizon will most likely be:
- lower than 2.00%.
- approximately equal to 2.00%.
- greater than 2.00%.
B is correct. If the investment horizon equals the (Macaulay) duration of the portfolio, the capital loss created by the increase in yields and the reinvestment effects (gains) will roughly offset, leaving the realized return approximately equal to the original yield to maturity. This relationship is exact if (a) the yield curve is flat and (b) the change in rates occurs immediately in a single step. In practice, the relationship is only an approximation. In the case of the domestic sovereign yield curve, the 20 bp increase in rates will likely be offset by the higher reinvestment rate, creating an annual return approximately equal to 2.00%.
