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%