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

Maturity (Years) YTM 1 10%

2 11 3 12

a. What are the implied one-year forward rates?

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. If you purchase a two-year zero-coupon bond now, what is the expected total rate of return over the next year? What if you purchase a three-year zero-coupon bond?

(Hint: Compute the current and expected future prices.) Ignore taxes.

LO.1