Problem 1. The current yield curve for default-free zero-coupon bonds is as foll

Question

Problem 1. The current yield curve for default-free zero-coupon bonds is as follows Maturity(years) YTM 10.0% 11.0% 12.0% 1. What are the implied one-year forward rates? 2. Assume that only the expectations hypothesis explains the shape of the term structure. If market expectations are accurate, what will the yield curve (that is, the yields to maturity on one- and two- year zero-coupon bonds) be next year? 3. If you purchase a two-year zero-coupon bond now, what is the expected total rate of return over the next year? What if you purchase a three year zero coupon bond? (Hint: compute the current and expected future prices.)

Explanation / Answer

1) Using expectation theory,

(1 + S2)^2 = (1 + S1) x (1 + 1F1)

Here, S2 - Current 2-year rate, S1 - Current 1-year rate, 1F1 - 1-year rate, 1-year from now

=> (1 + 11%)^2 = (1 + 10%) x (1 + 1F1)

=> 1F1 = 12.00%

2) One year rate next year = 12.00%

(1 + S3)^3 = (1 + S1) x (1 + 1F2)^2

=> (1 + 12%)^3 = (1 + 10%) x (1 + 1F2)^2

=> 1F2 = 13.01% is the two-year zero coupon bond a year later.

3) Over the next year, the return = 1F1 = 12.00% for both bonds.

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.