Question

Consider the following risk-free government bonds with fixed coupons that are paid annually at the end of every year. None of these bonds has any callable or puttable features. Assume that the t = 0 coupon has already been paid. The table below reports coupons, market prices, face values and the time to maturity for each bond. Assume that investors can freely buy and sell these bonds at the indicated market prices.

Bond	Coupon	Market Price	Face Value	Time to Maturity
B1	1%	$101	$100	1 year
B2	2%	$104	$100	2 years
B3	3%	$109	$100	3 years

Which of the following claims regarding the value of the three bonds is correct?

Group of answer choices

a, It is impossible to determine the relative values of all three bonds.

b, All three bonds are fairly valued.

c, Bond B1 is undervalued while bonds B2 and B3 are overvalued.

d, Bond B3 is undervalued while bonds B1 and B2 are overvalued.

e,All three bonds are undervalued.

f,Bond B2 is undervalued while bonds B1 and B3 are overvalued.

g,All three bonds are overvalued.

Answer 1

Solution) The yield-to-maturity (YTM) of the bonds can be calculated as follows:

From the above, we see that all the bonds are generating a yield-to-maturity of 0%. Thus, the spot rates of all the years is 0%

Hence, we can conclude that all the bonds are fairly valued. Thus, the correct option is (b).

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