Question

9. The market prices of zero coupon bonds are as follows Time to maturi Price 97.08 93.35 88.90 83.86 4 (a) Compute the one-year forward rate and the two-year forward rate one-year from now [i.e. compute fi2 and fi 31. Express them in annualized form. 4% and 4.5% (b) Suppose you can enter a contract to borrow or lend at a one-year forward rate [ h+2 ] of 4.5%. You can take long or short positions in any of the zero coupon bonds. Describe the strategy that you would implement to earn arbitrage profits Enter a forward contract to lend at 4.5%, buy one-year zero and short two-vear zero . (c) The liquidity premium is .25%. You buy the 2-year zero-coupon bond today What is the expected price of this bond at time 1? . 96.39

Answer 1

a) 97.8 bond issued with a 4% coupon rate pays 3.912 in interest annually regardless of the current market price of the bond.

Calculating Price

The price of a zero coupon bond can be calculated as:

Price = M / (1 + r)ⁿ

where M = Maturity value or face value of the bond

r = required rate of interest

n = number of years until maturity

97.8 / (1 + 4)4 = 4.89