QUESTION 3

Assume the current yield curve is as follows:

Maturity (years) Yield

1 2.500%

2 3.500%

3 4.000%

Assuming semi-annual compounding and that zero coupon bonds of all maturities are available, an investor wants to 'ride' the yield curve and considers the following strategies:

i.Buying a 2 year zero coupon bond today and holding it until maturity

ii.Buying a 3 year zero coupon bond today and selling it in two year's time

(a): What is the 2-year holding period yield from buying a two-year bond today and holding it to maturity?

(b): What is the 2-year holding period yield from buying a three-year bond today and selling it in two year's time?

(c): Assume that in one year's time, the yield curve will shift upwards by 0.50%. What is the 2-year holding period yield from buying a one-year bond today, holding it to maturity and then buying another one-year bond and holding it to maturity?

(d): What is f(1,2)?

(e): What is f(2,3)?