Spot rates and forward rates: Assume that the current yield curve for zero-coupon bonds (spot rates) is as follows: y1 = 0.5%, y2 = 0.75%, y3 = 1.0%, y4 = 1.25%, y5 = 1.5%

a. Plot the spot rates against maturity (yield curve). Is the yield curve upward or downward sloping? Do market participants expect interest rates to increase or decrease in the future?

b. What are the implied 1-year forward rates f2, f3, f4, and f5? Are interest rates expected to increase or decrease? Assume that there is no uncertainty about future short rates. This means that future 1 year interest rates will be equal to current forward rates (which you calculated in b).

c. In that situation what will be the spot curve (that is, the yields to maturity on 1, 2, 3, and 4-year zero coupon bonds) in 1 year?

d. What is the price of a 5-year coupon bond making annual coupon payments of 2% and a par value of 1000 today? Is the bond trading above or below par? Why?

e. What is the price of this bond next year (remember, it is then a 4-year coupon bond)? What is the rate of return on this bond over the next year?