Question 2: Term Structure of Interest Rates

Suppose that a 1-year zero-coupon bond with face value of 100 currently sells at 94.34, while a 2-year zero sells at 84.99. You are considering the purchase of a 2- year-maturity bond making annual coupon payments. The face value of the bond is 100 and the coupon rate is 12% per year. When answering the following questions show your work.

a) What is the yield to maturity of the 2-year zero?

b) What is the yield to maturity of the 2-year coupon bond?

c) What is the forward rate for the second year?

d) According to the expectations hypothesis, what are (i) the expected price of the coupon bond at the end of the first year and (ii) the expected holding period return on the coupon bond over the first year?

e) Will the expected rate of return be higher or lower if you accept the liquidity preference hypothesis?