The current prices of 1-year, 2-year and 3 year zero-coupon bonds are $930.00, $870.00
and $810, respectively.
Using the constant growth dividend discount model estimate the following:
a. Calculate the one year short rate in the third year.
b. How can you construct a synthetic two-year forward one-year loan of $5,000,000 with a
guaranteed cost (you commit now to borrow $5m for one year starting in two years
time)? State the strategy and show the corresponding cash flows. Assume that you can
purchase and sell fractional quantities of bonds. Show all working and and make clear
the meaning of the transactions
c. Prices of long term bonds are more volatile than prices of short term bonds. However,
market yields to maturity on short term bonds fluctuate more than yields on long term
bonds. How do you reconcile these two observations?
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