Problem 4: Par values of both the 1-Year zero and the 2-Year zero are $1,000. Su
ID: 2768839 • Letter: P
Question
Problem 4: Par values of both the 1-Year zero and the 2-Year zero are $1,000. Suppose that the short rate today is 6 percent and the expected short rate next year is 9 percent.
A. Find the price of the 2-Year zero under the Expectations Hypothesis.
B. Find the price at which the 2-Year zero can be sold after holding it for one year under the Expectations Hypothesis.
C. Suppose a short term-investor (one that is interested only in 1-Year investments) is willing to pay $800 for the 2-Year zero. Find the expected holding period return given this price that the investor is willing to pay.
D. Find the risk-premium implied by the expected holding period return.
E. Find the yield to maturity of the 2-Year zero given the par value and the price that the investor demands.
F. Find the forward rate implied by this yield to maturity.
G. Find the Liquidity Premium resulting from this forward rate.
Explanation / Answer
current price of zero coupon bond = face value * 1/1+R1 * 1/1+R2
= 2000 * 1/1.06 * 1/1.09
= $1731
premium = 1731 - 1600
= $131
Forward rate = (1+R2) ^2 / (1+R2) - 1
= 1.09 ^2 / 1.06 - 1
= 1.1208 - 1
= 12.08%
Risk premiun =
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