Problem Suppose that the log stochastic discount factor (SDF) in the economy is an AR(1) process: log + = (log + ) + , ~(0,2). Recall that with this SDF, the log 1-year yield, +1 +1 +1 log,1, is also an AR(1) process, and all other yields are expressed in terms of log,1. Suppose that the investors utility discount rate is =0.05, the persistence parameter is =0.8, and the volatility of shocks to the log stochastic discount factor is =0.05. Finally, let = 0 be today, = 1 be one year from now, etc. Questions: a. Using the unconditional distribution of the log SDF in the slides, compute the unconditional distribution of the log 1-year yield (this involves computing [log1] and [log1], and identifying a family of distributions to which the unconditional distribution of log 1 belongs). b. Suppose that the current (spot) 1-year yield is =2%. Using Excel (preferred) or Matlab, construct 0,1 the current zero-coupon yield curve for maturities of 1, 2, 3, 4, and 5 years. Present the result in the form of a graph (preferred) or table. c. You decide to purchase today a 5-year government bond with 2% annual coupon and $100 face value. What is the bonds current price, 0? d. Suppose that one year from now, the new spot 1-year yield is =4%. What is the new price of your 1,1 government bond, 1? What is the realized return that you have earned over the year? e. For this part of the question, disregard part d. Suppose that today there is a sudden increase in the current (spot) 1-year yield from = 2% to 4%. Is the modified duration informative in figuring out 0,1 how your government bonds price will change in response to this sudden change? Why or why not? You can explain your answer intuitively and/or using calculations. f. (difficult, but try to get as far as you can: partial credit will be given) What is the current expected next years price of your government bond, 0[1]? And what is the expected return you can earn over the year? Comment on similarities/differences of your answers to parts d. and f.