Question
You observe that the current three-year discount factor for default-risk free cash flows is 0.68. Remember, the t-year discount factor is the present value of
You observe that the current three-year discount factor for default-risk free cash flows is 0.68. Remember, the t-year discount factor is the present value of $1 paid at time t, i.e. D=(1+r)^-t, where r(t) is the t-year spot interest rate (annual compounding). Assume all bonds have a face value of $100 and that all securities are default-risk free. All cash flows occur at the end of the year to which they relate.
c) you observe the following: a 2-year coupon bond paying 10% annual coupons with a market price of $97, and two annuities that are trading at the same market price as each other. The first annuity matures in 3 years and pays annual cash flows of $20, while the second annuity pays annual cash flows of $28 and matures in 2 years. Using this information:
i. Complete the term structure of interest rates, i.e. determine the one- and two-year discount factors, d1 and d2, respectively.
ii. Determine the price of the annuities.
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