Bonds A and B have 3-year maturity. Bond A has coupon rate 2% and

trades at $985,76. Bond B has coupon rate 4% and trades at $1,042.92. A zero-coupon

bond with 1-year maturity trades at 977.52. All bonds have a face value of $1,000.

(a) [10 marks] Compute the one-year spot rate. Compute the two- and three-year

rates under the assumption that they are equal.

(b) [10 marks] Suppose that one year from today (just after bonds A and B pay the

rst coupon payments) the term structure becomes at at 2.45%. Compute the

one-year return of an investment in each of Bonds A and B. That is, the investor

buys a bond today, and sells it one year from today just after bonds A and B

pay the rst coupon payments. Compare the two returns (return of investing in

bond A to the return of investing in bond B) and explain the intuition behind the

comparison.

(c) [10 marks] Suppose that the investor holds Bonds A and B until maturity, invest-

ing the coupons at the relevant spot rates. Suppose that one year from today (just

after bonds A and B pay the rst coupon payments) theterm structure becomes

at at 2.45%. Suppose also that the term structure remains at at 2.45% until

the bonds mature. Compute the annualized three-year return of the investment

in each of the two bonds. Compare the two returns and explain the intuition

behind the comparison.