Problem Set 9

Foundations of Finance
Due Date: 1 Dec. 2016

Question 1:
Zero-Coupon Rates (treasuries)

12%
11.75%

Maturity

1
2

Your friend would like to borrow money from you for one year at the end of the first year what
would be the appropriate forward rate? Assume that your friend is not going to default on your
agreement.

Question 2:
The following is a list of prices for zero coupon bonds with different maturities and par value of
$1,000.
Maturity (Years)
1
2
3
4

Price
$943.40
$881.68
$808.88
$742.09

a. What is, according to the expectations theory, the expected forward rate for one year in
the third year, in other words the rate quoted today for investment starting at t=3 for one
year?
b. What is, according to the expectations theory, the expected forward rate for one year in
the second year, in other words the rate quoted today for investment starting at t=2 for
one year?
c. What is the yield to maturity on a 3-year zero coupon bond?

Question 3:
Suppose the yield to maturity on a one-year zero-coupon bond is 8%. The yield to maturity on a
two-year zero-coupon bond is 10%. Answer the following questions (use annual compounding):
(a) According to the Expectations Hypothesis, what is the expected one-year rate in the
marketplace for year 2?
(b)
Consider a one-year investor who expects the yield to maturity on a one-year bond to
equal 6% next year. How should this investor arrange his or her portfolio today?
(c)
If all investors behave like the investor in (b), what will happen to the equilibrium term
structure according to the Expectations Hypothesis?

Question 4:
zero coupon bond with 2.5 years to maturity has a yield to maturity of 25% per annum. A
3-year maturity annual-pay coupon bond has a face value of $1000 and a 25% coupon rate.
The coupon bond also has a yield to maturity of 25%. Does the longer maturity bond have
a larger interest rate sensitivity? Why or why not? Calculate for each bond the percentage
price change associated with a change of yield to maturity from 25% to 26%.

Question 5:
The yields on 1-year, 2-year and 3-year, risk-free, zero-coupon bonds are 2%, 2.5% and 3%, respectively.
a. What is the value of a 3-year, risk-free bond with a coupon rate of 4% (annual coupons) and a face
amount of $1,000?
b. What are the implied forward rates in the 2nd and 3rd years (f2 and f3)?
c. Under the expectations hypothesis, what are the expected yields on 1-year and 2-year zero coupon
bonds 1 year from now (at time 1)?

Question 6:
Excel exercises
This problem is to be completed in Excel. Please print out and hand in a copy of the Excel spreadsheet.
(Note that the problems above can also be done in Excel. However, the following problem MUST be
done in Excel.)
1. XYZ Inc. is expected to pay no dividends for the next 5 years. However, at the end of the sixth
year (at time 6), the company is expected to pay a dividend of $1/share. Dividends are expected
to grow at 10% per year for the following 9 years (through the end of the 15th year, i.e., time 15),
then to grow at 5% every year thereafter (forever). Assume the appropriate discount rate
(required return) is 10%.
a. What is the expected value of the stock at time 15?
b. What is the expected value of the stock at time 5?
c. What is the value of the stock today?