Suppose the yield to maturity on a one-year zero-coupon bond is 8%. The yield to

Question

Suppose the yield to maturity on a one-year zero-coupon bond is 8%. The yield to maturity on a two-year zero-coupon bond is 10%. Answer the following questions (use annual compounding):

(a) According to the Expectations Hypothesis, what is the expected one-year rate in the marketplace for year 2?

(b) Consider an investor who only wants to invest for a year. She expects the yield to maturity on a one-year zero to be 6% next year. In which one will she choose to invest for a year: the one-year zero-coupon bond or the two-year zero-coupon bond? [Hint: compare the holding period return for both bonds]

Explanation / Answer

a) ( 1 + 0.1)^2 = (1 + 0.08 ) * ( 1 +r)

r = 12.03%

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