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If the company were to issue an annual zero-coupon bond with a maturity of 2 years and a par value of $1,000, what would be the arbitrage-free price of that bond?

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Answer:

Step-by-step explanation:

[tex]\text{here is the missing text:} \\ \\ \text{ Suppose a company issues an annual coupon bond with a maturity of 2 years,} \\ \\ \text{ price of $950 \ par \ value \ of $1,000, and coupon rate of 5\% They also issue an}[/tex]

[tex]\text{ annual zero-coupon bond with a maturity of 1 year, price of $900, \ and \ par \ value \ of \ $1,000.}[/tex]

[tex]\text{To determine the 1-year spot rate using the 1-year zero bond.} \\ \\ FV = PV \times (1 + S_1) \\ \\ 1+ S_1 = \dfrac{FV}{PV} \\ \\ 1 + S_1 = \dfrac{1000}{900} \\ \\ S_1 = 11.11\%[/tex]

[tex]\text{PV of the 2-year bond = 950} \\ \\ Annual coupon = 1000 \times 5\% = \$50 \\ \\ \\ 950 = \dfrac{50}{(1+S_1) }+ \dfrac{(50+1000)}{(1+S_2)^2} \\ \\ 950 = \dfrac{50}{1.1111}+ \dfrac{1050}{(1+S_2)^2} \\ \\ \dfrac{1050}{(1+S_2)^2}=950 -45\\ \\ \dfrac{1050}{(1+S_2)^2}=905 \\ \\ (1+S_2)^2 = \dfrac{1050}{905} \\ \\ 1 + S_2= \sqrt{(1.16022)} \\ \\ S_2 = 7.714\%[/tex]

[tex]\text{the arbitrage-free price of the 2-year bond}= \dfrac{1000}{(1+0.07714)^2} \\ \\ = \mathbf{\$861.90}[/tex]

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