Chapter 7 The Term Structure and Interest Rate Dynamics 57 EXHIBIT 1 Current Par and Spot Rates Maturity Par Rate Spot Rate One year 2.50% 2.50% Two years 2.99% 3.00% Three years 3.48% 3.50% Four years 3.95% 4.00% Five years 4.37% Note. Par and spot rates are based on annual-coupon sovereign bonds. Nguyen gives Alexander two assignments that involve researching various questions: Assignment 1: What is the yield-to-maturity of the option-free, default-risk-free bond presented in Exhibit 2? Assume that the bond is held to maturity, and use the rates shown in Exhibit 1. EXHIBIT 2 Selected Data for $1,000 Par Bond Bond Name Maturity (7) Coupon Bond Z Three years 6.00% Note. Terms are today for a 7-year loan. Assignment 2: Assuming that the projected spot curve two years from today will be below the current forward curve, is Bond Z fairly valued, undervalued, or overvalued? After completing his assignments, Alexander asks about Nguyen's current trading activ- ities. Nguyen states that she has a two-year investment horizon and will purchase Bond Z as part of a strategy to ride the yield curve. Exhibit 1 shows Nguyen's yield curve assumptions implied by the spot rates. 27. Based on Exhibit 1, the five-year spot rate is closest to: A. 4.40%. B. 4.45%. C. 4.50%. 28. Based on Exhibit 1, the market is most likely expecting: A. deflation. B. inflation. C. no risk premiums. 29. Based on Exhibit 1, the forward rate of a one-year loan beginning in three years is clos- est to: A. 4.17%. B. 4.50%. C. 5.51%