Question

The term structure for zero-coupon bonds is currently: Maturity (Years) YTA (8) 4.6% 5.6 6.6 % 02:51:25 Next year at this time, you expect it to be: Maturity (Years) YTM (8) 5.60 6.6 7.6 a. What do you expect the rate of return to be over the coming year on a 3-year zero-coupon bond? (Round your answer to 1 decimal place.) Rate of return % b-1. Under the expectations theory, what yields to maturity does the market expect to observe on 1- and 2-year zeros at the end of the year? (Round your answers to 2 decimal places.) Maturity YTM b-2. Is the market's expectation of the return on the 3-year bond greater or less than yours? Greater Less

Answer 1

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Answer:

a.

Current year yield on a 3-year bond = 6.6%

Current price of 3-year bond with face value $100 = $100/1.066³ = $82.552

After one year, this 3-year bond shall be a 2-year bond having 2 years to maturity. Next year yield on a 2-year bond is 6.6%.

Price of 3-year bond next year = $100/1.066² = $88.00

Total return over the coming year = $88.00-$82.552 = $5.45

Expected rate of return over coming year = $5.45/$82.552 = 0.066 = 6.6%

b.

Forward rate for 2-year and 3-year bond on the basis of current year yield are as below:

Forward rate for 2-year bond = (1.056²/1.046)-1 = 0.0661 = 6.61%

Forward rate for 3-year bond = (1.066³/1.056²)-1 = 0.0863 = 8.63%

Using the forward rates calculated above, the forecasted next year are as below:

Forecasted yield for 1-year bond = 6.61%

Forecasted yield for 2-year bond = (1.0661*1.0863)^1/2 – 1 = 0.0762 = 7.62%

c.

The market forecasted return is higher than the our forecast.