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Question 1
You are looking at the valuation of some risk-free government bonds. It has been observed that the current 3-year discount factor for risk-free cash flows is 0.68. All bonds are assumed to have a par value of $100 and all cash flows occur at the end of the year.
(a) Propose the fair price for a zero-coupon bond that matures in exactly 3 years.
(b) Your friend makes the following comments about the above bond:"Since there is no risk of default and there are no coupons to reinvest, buying the 3-year zero-coupon bond today is a risk-free investment. In addition, the guaranteed risk-free annual rate of return is 13.72%."
Analyse if you would agree entirely with this statement.
(c) In addition to the bond observed in part (a), you also note the following:
(d) Assume that the observed discount factors are such that d1 < d2 < d3. Analyse why it would be odd to observe such a situation in a competitive market
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