Ten years ago (2012) your uncle purchased a Bank of Canada zero coupon bond that promised to pay $1,000 (Canadian) in 2032. Your uncle paid $376.89 (a promised return of 5%). Your uncle has just sold the bond for $508.35. He is upset - this means that he only earned a return of 3% over the 10 years he held the bond rather than the 5% he was expecting. He wants an explanation of how a risk free bond can return less than the promised return. Choose the best statement.

a. The Government of Canada bond is not risk free as it still is subject to default risk and inflation risk.

b. A zero coupon Government of Canada bond is only risk free if he holds it until maturity. At maturity he will receive the promised payment and his return will be 5%. Until maturity, the price of the bond is the present value of the promised payment discounted at the current interest rate.

c. A Government of Canada bond is only risk free if it is denominated in US dollars. The Canadian dollar fluctuates in value and his unexpected return is the result of changes in the Canada-US exchange rate.