Reference no: EM132660404
Please help with Part C, parts A and B are complete.
a) What are the current interest rates on 1-year, 2-year and 3-year bonds?
The current interest rates are 2.20%, 2.40%, and 2.6%.
b) Please calculate expected interest rates on 1-year bond next year and two years from now using expectations theory. Are they expected to grow, decrease or stay the same?
1 Yr Bond Next Year: Add 1 to the interest rate- 1+0.024= 1.024 Square of 1.024= 1.048576
Divide by (1+2.20%) = 1.026 Subtract 1= 0.026 Ans= 2.6%
1 Yr Bond Two Years: Add 1= 1.026 Square of 1.026= 1.052676
Divide by (1+2.20%)= 1.03 Subtract 1= 0.03 Ans= 3%
c) Now suppose you know that 2-year term premium is 0.6% and 3-year term premium is 0.8%. Please recalculate expected interest rates on 1-year bond next year and two years from now under liquidity premium theory. Again, are they expected to grow, decrease or stay the same? Compare this conclusion to the one in part (b) and explain the difference.
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