The term structure for zero-coupon bonds is currently: What do you expect the ra

Question

The term structure for zero-coupon bonds is currently:

What do you expect the rate of return to be over the coming year on a 3-year zero-coupon bond? (Round your answer to 2 decimal places. Omit the "%" sign in your response.)

Under the expectations theory, what yields to maturity does the market expect to observe on 1- and 2-year zeros at the end of the year? (Round your answers to 2 decimal places. Omit the "%" sign in your response.)

Is the market's expectation of the return on the 3-year bond greater or less than yours?

Explanation / Answer

a) At the end of the year, 3-year zero coupon rate = 7.7%

b) Using the expectation theory, (1 + S2)^2 = (1 + S1) x (1 + 1F1)

=> (1 + 6.7%)^2 = (1 + 5.7%) x (1 + 1F1)

=> 1F1 = 7.7% is the YTM on 1-year zero

Similarly (1 + S3)^3 = (1 + S1) x (1 + 1F2)^2

=> (1 + 7.7%)^3 = (1 + 5.7%) x (1 + 1F2)^2

=> 1F2 = 8.7% is the YTM on 2-year at year end.

b2) It is less.

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