2. Imagine that currently in the market the following bonds are available:

Maturity Coupon Rate Price

0.5 0% $ 97.087

1.5 8% $101.120

1.5 0% $ 89.900

2.0 0% $ 84.663

Maturity is in years, coupons are paid semiannually but quoted annually on a bond equivalent basis, and

prices are quoted per $100 face value.

(a) Construct a 2-year spot yield curve from this information. More precisely, calculate a spot rate for each

six-month period. Report the rate on a bond equivalent basis.

(b) In six months, your company plans to issue a 1.5 year zero coupon bond with a face value of $500,000 to

finance a small acquisition. If the traditional expectations theory of the term structure is correct, and if the

risk of your company's bonds is similar to that of the above bonds, what is the expected price of your

company's bond at issue (i.e., in six months hence)?

(c) Having heard reports that interest rates could rise sharply in the next six months, you suggest to the CFO

that the company issue the bond immediately, locking in current rates, and invest the proceeds in a six month

bond. In other words, today you would issue a bond maturing in two years with a face value of $500,000

("Bond X"). If you follow this strategy, how much money does the firm initially borrow? How much will be

available to finance the acquisition in six months?