The current yield curve for default-free zero-coupon bonds is as follows: a. Wha

Question

The current yield curve for default-free zero-coupon bonds is as follows:

a. What are the implied one-year forward rates? (Do not round intermediate calculations. Round your answers to 2 decimal places.)

b. Assume that the pure expectations hypothesis of the term structure is correct. If market expectations are accurate, what will the pure yield curve (that is, the yields to maturity on one- and two-year zero-coupon bonds) be next year?

c-1. If you purchase a two-year zero-coupon bond now, what is the expected total rate of return over the next year? (Hint: Compute the current and expected future prices.) Ignore taxes. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Expected total rate of return             %

c-2. If you purchase a three-year zero-coupon bond now, what is the expected total rate of return over the next year? (Hint: Compute the current and expected future prices.) Ignore taxes. (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Expected total rate of return             %

Explanation / Answer

a) Using expectation theory,

(1 + S2)^2 = (1 + S1) x (1 + 1F1)

Here, 1F1 - One year forward rate, one year later = (1 + 11.4%)^2 / (1 + 10.4%) - 1 = 12.41%

(1 + S3)^3 = (1 + S2)^2 x (1 + 2F1)

=> 2F1 = (1 + 12.4%)^3 / (1 + 11.4%)^2 - 1 = 14.43%

b) There will be upward shift as current 1 year rate is 10.4%, while a year later, the rate would be 12.41%

c) Next Rate of return = 1-year forward rate = 12.41% for both bonds.

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