Suppose the term structure of interest rates for risk-free zero-coupon bonds is as follows:

Term 1 year 2 year 3 year 4 year 5 year

Rate (EAR)%4.00 3.50 3.00 2.50 2.00

What is the fair price of a risk-free investment that pays $1,000 at the end of Years 1, 2, and 3, and given that price, what is the single rate of interest that could be used to fairly value this annuity? Choose the best answer.

a.$2,801.64; 3.34%

b.$2,810.19; 3.50%

c.$2,828.61; 3.00%

d.$2,820.14; 3.16%

e.$2,810.19; 3.34%

2. One year ago you bought what at that time was a 2-year zero-coupon bond. When you bought the bond, the 1-year spot rate was 3.0% and the 2-year spot rate was 4.0%.

Today, when the bond has 1 year remaining until maturity, you find that all spot rates of all maturities are 3.5%. What is your realized rate of return on the bond over the past year if you decide to sell the bond today? Choose the closest answer.

a.-0.50%

b.0.50%

c.3.00%

d.3.50%

e.4.00%

f.4.50%

3. Your firm must pay $1 million at the end of each of the next 3 years. It chooses to fund this obligation in an immunized way by purchasing 1,000 1-year bonds with a face value of $1,000 each, and similarly purchasing 1,000 2-year bonds (face value $1,000 each), and 1,000 3-year bonds (face value $1,000 each). The terminology in the notes for this approach is a:

a.Zero-coupon structured approach

b.Focused-maturity-based approach

c.Dedicated cash flow matching approach

d.None of the above