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## Finance 2

Below is a set of current (t = 0) prices on a set of zero-coupon bonds. The face value on all of these bonds is $1000. The prices below are quoted per$100 in face value. In answering the following questions, assume that you can buy fractions of a bond.

Bond Price

1-year zero 95

2-year zero 90

3-year zero 86

4-year zero 79

Also assume, for simplicity, that that each of these bonds matures in exactly a multiple of a year from now (now = t = 0).

A. If you invested in a two-year bond and rolled over into a one-year bond at t = 2, what would the one-year yield at t = 2 have to be in order for you to be indifferent between that strategy and investing in the three-year bond?

You have \$20,000 and want to make an investment that will allow you to have a down payment on a house in exactly two years. Consider the following two alternative strategies:

a.You can invest in the default-free 3-year zero-coupon bond and sell it after two years (at t = 2)

b. You can invest in the default-free 2-year zero-coupon bond.

A. Consider the first strategy (i.e., strategy a.) above.

a. If the forward rates implied by the bond price data above turn out to be the future rates that actually occur, what price (per \$100 in face value) will you get at t = 2 for the 3-year your bonds you are buying at t = 0?

b. If the forward rates implied by the bond price data above turn out to be the future rates that actually occur, what will be your holding period yield on the 3-year bond you are buying at t = 0? That is, what is the internal rate of return on the first strategy (i.e., strategy a.)?

c. If the forward rates implied by the bond price data above turn out to be the future rates that actually occur, how much money will you have at t = 2 under this first strategy (i.e., strategy a.)?

d. If it turns out that the one-year yield at t = 2 is 1 percentage point higher than the forward rate implied by the bond price date now, how much money will you have at t = 2 to use as a down payment?

e. If it turns out that the one-year yield at t = 2 is 1 percentage point lower than the forward rate implied by the bond price data now, how much money will you have at t = 2 to use as a down payment?

B. Now consider the second strategy (simply invest in the two-year bond). How much money will you have at t = 2 to use as a down payment? Does your answer depend upon what the one-year yields turn out to be at t = 2? Why or why not.

## Answers (1)

• Anonymous answered 7 hours later
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