3. Interest Rates

The term structure of zero rates is as follows:

Maturity (years)	Interest rate(%)
1	3.0
2	3.5
3	4.0

(a) Consider a 2-year government bond with the face value of $1,000. The bond will pay $20 coupon every year, including year 2. What is the present value of the bond in year 0?

(b) What is the implied forward rate r0(2, 3) with continuous compounding?

(c) Suppose that we consider borrowing $1,000 in year 2 and repaying in year 3. We want to fix now the interest rate for this borrowing. How can we achieve this using zero-coupon bonds? Show the table that lists the required bond positions and cash flows. 2 Ins