Question

You wish to loan some funds starting 1 year from now, in order to receive 1000 dollars 3 years from now. Suppose that the forward rate for that period is f1,3-0.07 (7 percent), compounded annually. The forward rate is the interest rate for money to be borrowed or loaned between two dates in the future, but under terms agreed upon today. A suitable contract that implements this loan would be an agreement with a bank to deliver to you, 1 year from now, a Treasury bill with 2 years to run from the delivery date. No funds change hands now: 1 year from now, you will pay the bank a certain price, and the bank will deliver the T- bill to you. Considering this arrangement as a loan that you make, in 1 year from now you will loan dollars and in 3 years from now you are repaid (by cashing in the T-bill) The discount factor for the period from 1 year from now to 3 years from now is:_______.

Answer 1

Answer and Explanation:

The computation is shown below:

Given that

Forward Rate = F (1,3) =7% compounded annually.

In addition to this, a T Bill is a zero coupon bond that matures three years from now.

So, T bill would be held for a period of 2 years.

Now

Let us assume the market price of the bond 1 year from now be P1

So,

P1 = 1000 ÷ (1.07)^(2)

= $873.44

So, the Amount Loaned in exchange for T-Bill is $ 873.44

And, Amount collected upon T Bill redemption i.e after three years from now) is

= $1,000 = Par value of T-bill

And, Discount Factor is

= 1 ÷ (1.07)^(2)

= 0.87344