4.-The current yield curve for default-free zero-coupon bonds is as follows: Mat

Question

4.-The current yield curve for default-free zero-coupon bonds is as follows: Maturity (Years)e YTM 10% 11%- e All bonds considered in this question have a face value of S1,000. Assume that the pure expectations hypothesis of the term structure holds.e' a. Ifmarket expectations are accurate, what are the expected yields to maturity on 1 and 2-year zero coupon bonds next year?4 (3 marks)e b. -Ifyou purchase a 3-year zero-coupon bond now, what is the expected total rate of return over the next year assuming that you will sell the bond at the expected price (3 marks) c. . What should be the current price ofa 3-year maturity bond with a 12% coupon (3 marks) d.- If you purchase the coupon bond at the price you calculated in part c), what would (price that matches the expected yield in part a))? Ignore taxes. rate paid annually? your total expected rate ofreturn over the next year be (coupon plus price change)? Ignore taxes.

Explanation / Answer

1.

1 year=(1+10%)^2/(1+9%)-1=11.01%

2 year=((1+11%)^3/(1+9%))^0.5-1=12.01%

2.

Price of 3 year zeroc oupon bond now=1000/1.11^3=731.1914

Price of 3 year zeroc oupon bond 1 year later=1000/1.1201^2=797.0515406

Return=797.0515406/731.1914-1=9.01%

3.

Price=1000*12%/1.09+1000*12%/1.1^2+1000*12%/1.11^3+1000/1.11^3=1028.20

4.

Price next year=1000*12%/1.1101+1000*12%/1.1201^2+1000/1.1201^2=1000.80

Return=(1000.80+1000*12%)/1028.20-1=9.01%

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