2. Spot rates and forward rates (30 points): Assume that the current yield curve for zero-coupon bonds (spot rates) is as follows: y1 = 4.5%, y2 = 4.75%, y3 = 4.5%.

a. What are the implied 1-year forward rates f2 and f3? Assume that there is no uncertainty about future short rates, i.e. that future short rates (future 1 year yields) will be equal to current forward rates (so future short term interest rates will be equal to f2 and f3).

b. In that situation what will be the spot curve (that is, the yields to maturity on 1- and 2-year zero coupon bonds) in 1 year?

c. What is todays price of a 3-year zero coupon bond with par value of 1000 from a? - And IF y3 declines to 4.0% because inflation is contained, so economy recovers.

d. What is the price of this bond next year (remember, it is then a 2 year zero coupon bond)? What is the rate of return on this bond over the next year?