Assume that main line of business is expected to receive $1,000,000 exactly 1.5 year from today (t=1.5 years). You do not expect any cash outflow for the next 6 months (i.e. from t = 1.5 to 2.0 years). Use the following information to explain how you can "Lock in" an interest rate for this period. The current price of the 1.5 year zero coupon bond is 86.0708 and the 2.0 year zero coupon bond is $78.6628. (Please show all workings)
a) What is the continuously compounded (annual) interest rate you can expect to earn with certainty over this period (1.5 to 2.0 years)? In other words, what is the forward rate from 1.5 to 2.0 years.
b) Clear show what transactions you will undertake today and their future effects that will help you "lock in" the above rate.
c) What is the amount you will receive at the end of year 2.0 as opposed to $1,000,000 at the end of year 1.5?