Question

The yield on a one year bond is 3%. The expected yield on a one year bond, one year in the future is 4%. The expected yield on a one year bond in 2 years is 5%. The liquidity premium 0.5(n-1)%. The "3-2" spread is _____ .

1. -.5%
2. -1%
3. 0%
4. 0.5%
5. 1%

The yield on a one year bond is 3%. The expected yield for the one year bond a year later is 4%. The expected yield for the one year bond in 2 years is 5%. According to the expectations hypothesis, the yield on a three year bond should be _____.

a.3%

b.4%

c.5%

d.None of the above

Answer 1

1. 1%

Reason: Yields on long-term bonds are greater than the expected return from rolling over short-term bonds in order to compensate investors in long-term bonds for bearing interest rate risk. Thus bond of different maturities can have different yields even if expected future short rates are all equal to the current short rate An upward sloping yield can be consistent even with expectations of falling short rates if liquidity premiums are high enough. If, however, the yield curve is downward sloping and liquidity premiums are assumed to be positive, then we can conclude that future short rates are expected to be lower than the current short rate

2. (d) None of the above

Reason: The yields on long-term bonds are geometric average of present and expected future short rates. An upward sloping curve is explained by expected future short rates being higher than the current short rate A downward sloping yield curve implies expected future short rates are lower than the current short rate. Thus bonds of different maturities have different rate yields if expectations of future short rates are different from the current short.