1. Suppose the data on today’s and future expected interest rates is given: Time Yield on...

1. Suppose the data on today’s and future expected interest rates is given:

Time	Yield on 1-year T-bond
Today	1.2%
Next year	1.2% (expected)
2 years from today	1.6% (expected)
3 years from today	2.0% (expected)

a) Calculate today’s interest rates on 2-year, 3-year and 4-year bonds using the expectations hypothesis. Use these yields to construct a yield curve and plot it. What kind of shape does it have?

b) Now, suppose term premiums for 2-year, 3-year and 4-year bonds are 0.2%, 0.3% and 0.4%, respectively. Recalculate today’s interest rates on 2-year, 3-year and 4-year bonds using the liquidity premium theory. Use the yields to plot the yield curve on the same graph as expectations hypothesis yield curve from part (a). What do you notice?

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Expert Solution

Rahul Sunny answered 1 year ago

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