Question 3:

You will receive $1M one year from now, but will not need to use it until

three years from now. You thus need to invest the $1M for two years.

a.

[3 marks]

Suppose that you want to guarantee a rate today for your investment.

What is the relevant rate for such an investment?

b.

[3 marks]

Suppose that the one-year spot rate is 6% and the three-year spot rate

is 7%. Compute the rate in (a).

c.

[9 marks]

Suppose that you are unable to contact a bank that oers the rate in

(a). You can contact, however, a dealer who trades zero-coupon bonds. Explain

how you can use zero-coupon bonds (i.e., what bonds you use and how you trade

them) to lock in the rate in (a).