Suppose the current yield curve based on zero-coupon Treasury bonds (STRIPS) is as follows:

Assume that there are no arbitrage opportunities in bond markets, and ignore transaction costs. At prices determined by these rates, A has just invested $1,000 in 1-year STRIPS; B has invested $1,000 in 2-year STRIPS, and C has invested $1,000 in 3-year STRIPS. All three investors will liquidate their positions in exactly one year.

a. Suppose the zero-coupon Treasury yield curve one year from now is identical to the current yield curve. Which of the three investors will have earned the highest per dollar return?

b.Now suppose a riskless four-year coupon bond with a $100 face value and annual coupon payments is trading in financial markets, in addition to the three riskless zero-coupon bonds described above. The coupon rate of the four-year bond is 5.00% (paid annually), and the bond is trading at par (i.e., its current market price is equal to its face value). What is the yield to maturity of a riskless four-year zero coupon bond?

Maturity One Year Two Years Three Years Yield to Maturity 3.25% 4.50% 4.80%