Problem
Suppose a current 3-month interest rate is 4.05%. The cash prices of six-month and nine-month Treasury bills are £97 and £94, respectively. A one-year bond that has a coupon rate of 5% and will pay coupons quarterly currently sells for £96. A two-year bond that will pay coupons of £4 annually currently sells for £90.
• Explain the role of the zero rates in the financial decisions and how they differ from the forward rates. Can the rates calculated from the observed prices of Treasury bills and bonds in this exercise be used as the risk-free rates? Explain.