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he spot rate for three hypothetical zero-coupon bonds (zeros) with maturities of

ID: 2641218 • Letter: H

Question

he spot rate for three hypothetical zero-coupon bonds (zeros) with maturities of one, two and three years are given in the following table (based on annual compounding).

Maturity(T)

1

2

3

Spot rates

r(1)=11%

r(2)=10%

r(3)=9%

(a) Calculate the forward rate for a one-year zero in one year, f (1,1).

(b) Calculate the forward rate for a one-year zero in two years, f (2,1).

(c) Calculate the forward rate for a two-year zero in one year, f (1,2).

(d) Calculate the price for a 3-year treasury bond with par value of $1,000 and having a 5% coupon rate paid annually.

Maturity(T)

1

2

3

Spot rates

r(1)=11%

r(2)=10%

r(3)=9%

Explanation / Answer

Forward rates are calculated using the sopt rates. As in the above question the spot rates are given forward rates are:

A) Forward rate for a one-year zero in one year

Let the forward rate be = f

Spot rate = 11% for bond maturing in 1 year

Now forward rate for a one-year zero in one year will be 0% as one year rate are already provided

f = 0%

B) Forward rate for a one year zero in two year

Let forward rate be = f

Then, (1+11%) * (1+f) = (1+10%)^2

f = 9.01%

C) Forward Rate for two-year zero in one year

Let forward rate = f

Then,

(1+10%)^2 * (1+f) = (1+9%)^3

f = 7.027%

D) Price of 3-year treasury bond with par value $ 1,000 at 5% coupon rate annually paid

Price of bond = Present Value of the bond

Present Value of the bond = Present value of coupon payments + Present Value of maturity value of bond

Year

Inflows (A)

Present Value at 9% for $ 1 (B)

Total Amount (A*B)

1

$              50

0.917431193

$                          45.87

2

$              50

0.841679993

$                          42.08

3

$              50

0.77218348

$                          38.61

3

$        1,000

0.77218348

$                        772.18

Grand Total

$                        898.75

Price of Bond = $ 898.75

Year

Inflows (A)

Present Value at 9% for $ 1 (B)

Total Amount (A*B)

1

$              50

0.917431193

$                          45.87

2

$              50

0.841679993

$                          42.08

3

$              50

0.77218348

$                          38.61

3

$        1,000

0.77218348

$                        772.18

Grand Total

$                        898.75