Analysts predict that short-term interest rates over the next 4 years will be as

Question

Analysts predict that short-term interest rates over the next 4 years will be as follows: 13%, 2%, 7%, and 10%, respectively. According to expectations theory, the yield on a discount bond with a three year maturity will be ____ and yield on bond with a four year maturity will be ____.

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Question 51 pts

Consider the same short-term interest rates as in problem 4 above. If the yield on a discount bond that matures in 4 years is 8.25%, then according to liquidity premium theory, the premium attached to the 4 year discount bond is

Explanation / Answer

The yield on a discount bond with a three year maturity will be (13% + 2% + 7%)/3 = 7.33%

and yield on bond with a four year maturity will be

(13 + 2 + 7 + 10)%/4 = 8%

Thus, answer is 7.33%, 8%

According to liquidity premium theory,

Premium attached to the 4 year discount bond = 8.25% - (13 + 2 + 7 + 10)%/4 = 8.25% - 8% = 0.25%

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