Investments, tenth edition

 Figure 15.2 

Two 2-year investment programs  

0

1

2

Time Line

Alternative 1: Buy and

hold 2-year zero

Alternative 2: Buy a 1-year

zero, and reinvest proceeds in

another 1-year zero

$890

$890

$934.50(1 

+ r

2

)

$890 

×1.06

2

 

= $1000

2-Year Investment

1-Year Investment

1-Year Investment

    $890 

× 1.05

 

= $934.50

bod61671_ch15_487-514.indd   491

bod61671_ch15_487-514.indd   491

7/17/13   4:03 PM

7/17/13   4:03 PM

Final PDF to printer

---

492 

P A R T   I V

 Fixed-Income 

Securities

Thus, at least in part, the yield curve reflects the market’s assessments of coming interest rates. 

The following example uses a similar analysis to find the short rate that will prevail in year 3. 

 Use  Table 15.1  to find the short rate that will prevail in the fourth year. Confirm that the discount factor 

on the 4-year zero is a geometric average of 1 1  the short rates in the next 4 years. 

 CONCEPT CHECK 

15.2 

 

 

 

 

Figure  15.3 

 summarizes the results of our analysis and emphasizes the difference 

between short rates and spot rates. The top line presents the short rates for each year. The 

lower lines present spot rates—or, equivalently, yields to maturity on zero-coupon bonds 

for different holding periods—extending from the present to each relevant maturity date.