Question

The current 1-year spot rate is 3.5%. The annual volatility of interest rates is 10%. If r r1,L =4.5%, calculate the price of a 2-year bond with an annual 3% coupon (paid annually). Assume a face value of $100.

Answer 1

To calculate the price of a 2-year bond with an annual 3% coupon (paid annually), discount the future cash flows using the current 1-year spot rate and the annual volatility of interest rates.

Step-by-step explanation:

To calculate the price of a 2-year bond with an annual 3% coupon (paid annually), we need to discount the future cash flows using the current 1-year spot rate and the annual volatility of interest rates. First, calculate the present value of the coupon payments: $3 coupon payment for the 1st year discounted by the 1-year spot rate + $3 coupon payment for the 2nd year discounted by the 2-year spot rate. Next, calculate the present value of the face value payment: $100 face value payment for the 2nd year discounted by the 2-year spot rate. Add the present values of the coupon payments and the face value payment to get the price of the bond.