Question 3 2018:

Suppose that the current one-year interest rate is at 2%, the two-year rate is at 2.5% and the three-year rate is at 3%. A trader quotes the one-year rate, one year forward as 2.8%. Assume that there is no bid-ask spread (i.e., you can lend and borrow at the same rate) and that no other trader is quoting in the forward market. a) What is the one-year forward rate for a contract that expires in one year (i.e., the forward rate for a contract to lend or borrow in one year for one year)? b) Describe a trade that you could implement to profit from this quote. c) How would you trade if the one-year forward rate quoted by the trader was 3.3%? d) If your forecast is that the yield curve will be the same next year, how can you trade to benefit from this prediction, if possible? e) Calculate the one-year forward rate for a contract that expires in three years. f) Briefly explain whether the forward curve described by the one-year forward rates in parts (a) and (e) is in contango or backwardation. g) Suppose the forward curve consists of the following forward rates: 1-year spot rate: 2.0% 1-year rate, one year forward: 3.0% 1-year rate, two years forward: 4.0% What is the value per 100 of par value of a three-year bond with a coupon of 4% with interest payments paid annually?