Practice Quiz 3 — Forward Rates & Credit Spreads

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The current spot rates are: r(1) = 5%, r(2) = 6%.

A 2-year risk-free zero-coupon bond (face value $100) trades at a price implied by r(2). A 2-year corporate zero-coupon bond (same face value) trades at $86.

(a) Compute the 1-year forward rate f(1,2) implied by the spot curve. Is the market expecting short-term rates to rise or fall next year?

(b) What is the price of the risk-free zero-coupon bond? What is the YTM of the corporate bond? Is the corporate bond trading at a positive or negative spread to Treasuries?

(c) In one sentence, explain what a positive credit spread compensates the investor for.