FIN 2200 – CORPORATION FINANCE
Sum 2007
Instructors: A. Dua
Assignment #4 key
1.
Spot rates of interest for zerocoupon Government of Canada bonds are observed for
different terms to maturity as follows:
Term to maturity
Rate (r
i
)
1 year from today
5.75%
2 years from today
6.25%
3 years from today
6.35%
4 years from today
6.25%
5 years from today
6.40%
a)
What is the forward rate of interest from year 2 to year 3, i.e., what is f
3
?
%
550282
.
6
1
)
0625
.
1
(
)
0635
.
1
(
1
)
r
1
(
)
r
1
(
f
2
3
2
2
3
3
3
=

=

+
+
=
b)
What is the forward rate of interest from year 3 to year 4, i.e., what is f
4
?
%
950564
.
5
1
)
0635
.
1
(
)
0625
.
1
(
1
)
r
1
(
)
r
1
(
f
3
4
3
3
4
4
4
=

=

+
+
=
c)
If you believe in the pure expectations theory, what does your answer to (a) imply
about E[
2
r
3
]? If you believe in the augmented expectations theory, what does your
answer to (a) imply about E[
2
r
3
]?
pure expectations: E[
2
r
3
] = f
3
= 6.550282%; i.e., same 1 year rate 2 years from
now.
augmented expectations: E[
2
r
3
] < f
3
or < 6.550282%; i.e., lower 1 year rate 2
years from now.
d)
If you believe in the pure expectations theory, what does your answer to (b) imply
about E[
3
r
4
]? If you believe in the augmented expectations theory, what does your
answer to (b) imply about E[
3
r
4
]?
pure expectations: E[
3
r
4
] = f
4
= 5.950564%; i.e., same 1 year rate 3 years from
now.
augmented expectations: E[
3
r
4
] < f
4
or < 5.25352388%; i.e., lower 1 year rate 3
years from now.
e)
Suppose a zerocoupon bond has a face value of $1,000 and matures 5 years from
today.
i)
What is its price today?
32
.
733
$
)
064
.
1
(
000
,
1
)
r
1
(
FV
PV
price
5
T
flows
cash
future
=
=
+
=
=
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View Full DocumentFIN 2200 – CORPORATION FINANCE
Sum 2007
Instructors: A. Dua
Assignment #4 key
ii)
If you believe in the pure expectations theory, then what do you expect its
price to be four years from today?
56
.
934
$
0700212064
.
1
000
,
1
]
price
[
E
%
00212064
.
7
)
0625
.
1
)
064
.
1
(
)
r
1
(
)
r
1
(
f
f
rate
at
year
1
discounted
$1,000
equal
should
price
4
5
4
4
5
5
5
5
=
=
=
=
+
+
=
=
f)
Suppose a bond has a 6% annual coupon, a face value of $1,000 and matures in 2
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 Three '09
 JAMES
 Net Present Value, Internal rate of return, CORPORATION FINANCE Sum, IRRA

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