Question

Please use this information for the next 3 questions.

At your favorite bond store, Easy Bonds, you see the following prices:

• One year zero selling for $90.09
• Three year 10% coupon $1,000 par bond selling for $1,000
• Two year 10.5% coupon $1,000 par bond selling for $1,000

Assume that the expectations theory of interest rates holds, no liquidity premium exists and that the bonds are equally risky and liquid. What is the current one year rate?

What is the implied one-year rate for the second year?

What is the implied one-year rate for the third year?

Answer 1

As per calculation shown below implied interest rate would be 10 % for first year 10% for second year 9 % for third year.

	Assumtion that the expectations theory of interest rates holds, no liquidity premium exists and that the bonds are equally risky and liquid.
	hence difference in the two year yeild is due to differencial time period
		1 year bond	2 year bond	3 year bond
	total value of cash flow (lets assume we have invested $1000 to make it comperable )
		$                  1,110.00	$               1,221.03	$                     1,331.00
		1000*100/90.09	FV(10.5%,2,,-1000,1000)	FV(10%,3,,-1000)
	To calculate Implied rate we need to compere year on year	10%	10%	9%
			(D8/C8)-1	(E8/D8)-1