Consider the Following Two Bonds: a Discount Bond Paying 100

question 67

Essay

Consider the following two bonds: a discount bond paying 100 in one year,selling at 93; a coupon bond paying 10 in one year,110 in two years,selling at 95.
a. What is the one-year spot rate? What is the forward rate for the second year?
b. Suppose there is a liquidity premium of 50 basis points on two-year lending. What is the market's expectation of what the one-year spot rate will be in the second year? What does the market expect the second bond's price to be at the beginning of the second year?
c. Suppose you are in the 40% effective marginal tax bracket. What is the total amount you expect to have after taxes at the end of year 2 if you buy the second bond? (Don't forget to reinvest the first-year coupon.)
d. Suppose you buy the second bond and then the market's expectation of the spot rate in the second year changes to 10%. What would be the immediate price change on the bond? If you sold the bond right away, what would be your after-tax profit or loss?

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