Consider the following bonds, each with a face value of $100:

Type of bond Maturity Coupon Price YTM

Zero-coupon 1 0 96.32 3.82%

Zero-coupon 2 0 Po 4.60%

Zero-coupon 3 0 89.11 у

Annual coupon 2 5% Pcoupon

Answer the following questions:

1. What is the price of the 2-year zero-coupon bond (P.)? (10p)

2. What is the yield to maturity of the 3-year zero-coupon bond (y)? (10p)

3. Which price would be consistent with no arbitrage for the annual-pay coupon bond (i.e., a

bond that pays $5 after one year and $105 after two years)? (15p)

Step-by-Step explanation
Calculate the price with no-arbitrage for the annual-pay coupon bond are as follows:
 
Year1 Payment = $5
Year 2 Payment = $105
YTM1 = 3.82%
YTM2 = 4.60%
4. Suppose that the coupon bond trades at a price of $101.00.

a. What arbitrage trade would you do? (15p)

b. Suppose that you hold this arbitrage position until maturity in two years. What will be your

profit in dollars? What is the annual return as a percentage of the value of the long side of the

position? (15p)

Answer:
Expectations concept tries to are expecting what short-time period hobby fees might be
withinside the destiny primarily based totally on modern long-time period hobby fees.
The concept shows that an investor earns the identical hobby via way of means of
making an investment in consecutive one-12 months bond investments as opposed to
making an investment in a single -12 months bond today. The concept is likewise
referred to as the "impartial expectancies concept." Let's say that the prevailing bond
marketplace presents buyers with a -12 months bond that can pay an hobby price of
20% even as a one-12 months bond can pay an hobby price of 18%. The expectancies
concept may be used to forecast the hobby price of a destiny one-12 months bond. The
first step of the calculation is to feature one to the -12 months bond's hobby price. The
end result is 1.2. The subsequent step is to rectangular the end result or (1.2 * 1.2 =
1.44). Divide the end result via way of means of the modern one-12 months hobby price
and upload one or ((1.44 / 1.18) +1 = 1.22). To calculate the forecast one-12 months
bond hobby price for the subsequent 12 months, subtract one from the end result or
(1.22 -1 = 0.22 or 22%). In this example, the investor is incomes an equal go back to the
prevailing hobby price of a -12 months bond. If the investor chooses to put money into a
one-12 months bond at 18%, the bond yield for the subsequent 12 months's bond could
want to boom to 22% for this funding to be advantageous. The expectancies concept
pursuits to assist buyers make selections primarily based totally upon a forecast of
destiny hobby fees. The concept makes use of long-time period fees, commonly from
authorities bonds, to forecast the price for short-time period bonds. In concept, long-time
period fees may be used to suggest in which fees of short-time period bonds will
exchange withinside the destiny. The favored habitat concept takes the expectancies
concept one step further.  In different words, if buyers are going to preserve onto a long-
time period bond, they need to be compensated with a better yield to justify the danger
of protecting the funding till adulthood. The favored habitat concept can assist explain, in
part, why longer-time period bonds commonly pay out a better hobby price than shorter-
time period bonds that, whilst brought together, bring about the identical adulthood.
When evaluating the favored habitat concept to the expectancies concept, the distinction
is that the previous assumes buyers are worried with adulthood in addition to yield. In
contrast, the expectancies concept assumes that buyers are handiest worried with yield.
Investors have to be conscious that the expectancies concept isn't usually a dependable
tool. A not unusual place hassle with the usage of the expectancies concept is that it
from time-to-time overestimates destiny short-time period fees, making it clean for
buyers to turn out to be with an erroneous prediction of a bond's yield curve. Another
issue of the concept is that many elements effect short-time period and long-time period
bond yields. The Federal Reserve adjusts hobby fees up or down, which influences bond
yields, along with short-time period bonds. However, long-time period yields is probably
much less affected due to the fact many different elements effect long-time period yields,
along with inflation and monetary boom expectancies. As a end result, the expectancies
concept does now no longer take into account the outdoor forces and essential
macroeconomic elements that pressure hobby fees and, ultimately, bond yields. 

5. What is the forward rate from time 1 to time 2 implied by the above zero-coupon bond

prices? (10p)

6. Suppose that you believe that the 1-year interest rate will be 4% in one year from now

(based on your views on central bank policy). What trade would you consider as a result of

the difference between your view and the forward rate? (25p)