Given the yield curve (recall this is for zero coupon government debt) below and a belief in the expectations hypothesis,

y1 = 5%

y2 = 4.5%

y3 = 4.25%

y5 = 4%

y7 = 3.5%

y10 = 3.75%    

 

a. What is the interest rate from the end of year 2 to the end of year 3? (3 points)

b. What is the annualized forward interest rate from the end of year 1 to the end of year 5?

c. At what rice would a zero-coupon bond that matures at the end of year 10 sell for at the end of year 3?

1. d. Suppose your investment horizon is five years. Calculate your expected annual return from the following three strategies:
2. Buy a two-year bond now; at t=2 use your proceeds to buy a three-year bond.
3. Buy a three-year bond now and at t=3 use the proceeds to buy a two-year bond.
4. Buy a ten-year bond now and sell it at t=5.

e. A five-year corporate bond pays a 5% coupon annually and its required return is 1.5% above the US Treasury rate. What is the price of the corporate bond?

f. Assuming that you can reinvest the coupons at the implied forward rates and that you sell the bond immediately after receiving the third coupon payment, what is your wealth after selling the bond?

g. Given your answer in (f), what is your annualized rate of return over the three-year period?