Question 4

Consider the following information about default-free bonds:

Years to Maturity	Zero-Coupon Bond Yield	Zero-Coupon Bond Price	One-Year Implied Forward Rate	Par Coupon	Cont. Compounded Zero Yield
1	6.00%	0.943396	6.00000%	6.00000%	5.82689%
2	6.50	0.881659	7.00236	6.48423	6.29748
3	7.00	0.816298	8.00702	6.95485	6.76586

Suppose you buy a 3-year par coupon bond and hold it for 2 years, after which time you sell it. Assume that interest rates are certain not to change and that you reinvest the coupon received in year 1 at the 1-year rate prevailing at the time you receive the coupon. Verify that the effective annual 2-year return on this investment is 6.5%.