On EOC Questions 35 & 36 for Term Structure and Interest Rate Dynamics
#35 Assignment 2: says you assume that the projected spot curve two years from today will be below the current forward curve, is Bond Z fairly/under/overvalued.
Exh 1:
Par Rate 1yr (2.5%),2yr (2.99%), 3yr (3.48%), 4yr (3.95%), 5yr (4.37%)
Spot Rate 1yr (2.5%),2yr (3.00%), 3yr (3.50%), 4yr (4.00%)
1 - Is the current forward curve in this assumption referring to the spot rates in exhibit 1? The only list of rates given in exhibit 1 are Par Rates and Spot rates.
2 - If 1 is correct, then I understand that the projected spot curve being below the forward curve implies a downward sloping yield curve but why does my bond with a YTM of 3.46% considered undervalued? The answer talks about the market discounting at a higher rate (so does this implies the market has a high rate than 3.46%?), which seems to contradict that the spot curve is below the forward curve?
#36 In choosing to buy Bond Z, Nguyen is making the assumption the 3 year forward curve is above the spot curve. How does my YTM at 3.46%, correlate to this assumption? Is it because my YTM is less than the current 3 year spot rate of 3.5%? Or is there something else that would tell me this?
Side question - Why is B the answer instead of A. If I held to MTY wouldn’t my YTM be less than the spot rate, thus resulting in a higher bond price? Where is the 6% coupon considered in this answer? Do I compare par rates for this question?
Thanks for any help