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Description of Forward contract

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You enter into a forward contract to buy a 10-year, zero coupon bond that will be iussued in one year.
The face value of the bond is $1000, and the 1-year and 11-year spot interest rates are 3 percent per annum
and 8 percent per annum, respectively. Both of these interest rates are expressed as effective annual yiels (EAY's).

a) What is the forward price of your contract?

b) Suppose both the 1-year and 11-year spot rates unexpectedly shift downward by 2 percent. What is the price
of a forward contract otherwise identical to yours?

Please show the mathematical calculations

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Solution Summary

A step-by-step explanation is given on finding the forward price of contracts with unexpected downward shifts.

Solution Preview

a. In order to get the price of the contract, we should first find the 1 year forward 10-yr interest rate. This value can be found using arbitrage arguments. The 11-yr rate is 8%. Therefore, an 11-year investment of $1 today would return

1.08^11 = 2.331...

in 11 years. This investment is equivalent to invest $1 today for 1 year (at the 1-yr ...

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