Bond Problem. This problem is designed to utilize your knowledge about the term structure of interest rates.

You are given the following information about three bonds that have recently been traded. Bond A B C Price Year 0 $977.18 $1026.37 $245.93 Year 1 100 120 100 Cash Flows Year 2 100 1120 100 Year 3 1100 0 100

a. Its possible to create pure discount bonds with face values of $1000 and maturities of 1, 2, and 3 years by combining different quantities of the bonds above (those may involve fractions of bonds and positive and negative quantities of bonds). Calculate exactly what weights (amounts) you would use to create: a. A one period pure discount bond b. A two period pure discount bond c. A three period pure discount bond b. What would these bonds trade for based on the current prices of A, B, and C.? c. Solve for the spot rates, r1, r2, r3, (i.e. the YTMs on the deep discount bonds). d. Plot the zero coupon yield curve e. Using the rates in c. calculate the NPV of a project that costs $1217 and pays out $840 in year 1, $340 in year 2, and $290 in year 3. Should you take the project? f. What are the forward rates f1,2 and f2,3 g. You are working for a large institutional investor. Another large firm offers to lend your firm $1m between periods 2 and 3 at a rate of 11%. Do you accept? Explain. h. Someone offers your firm a chance to buy a three period zero coupon bond (bond X) with a payout (face value) of $1000 for $731. What is theYTM on this bond? What is the YTM on bond C? Is the bond a good deal? Why or why not?

i.

Someone offers to buy a bond (bond Z) with the following cash flows from your firm for $1598.88, claiming that this is a fair price because it would imply the same YTM as bond C. Year

1 2 3 500 500 1000 Verify that the YTM on bond Z is the same as on bond C. Should you go ahead and sell the bond at the price? Explain why or why not?