7.* Suppose that the yield curve shows that the one-year bond yield is 3 percent

Question

7.* Suppose that the yield curve shows that the one-year bond yield is 3 percent, the two-year yield is 4 percent, and the three-year yield is 5 percent. Assume that the risk premium on the one-year bond is zero, the risk premium on the two-year bond is 1 percent, and the risk premium on the three-year bond is 2 percent. (LO2) a. What are the expected one-year interest rates next year and the following year? b. If the risk premiums were all zero, as in the expectations hypothesis, what would the slope of the yield curve be?

Explanation / Answer

a) 2nd year interest rate = 3%+4%/2 +1% premium risk= 4.5%

3rd year interest rate = 3%+4%+5%/3+2% premium risk=6%

b)  the liquidity premium theory predicts that interest rates of different maturities will move together because the long-term rates are essentially tied to the short-term rates. Long rates will also be less volatile because part of the long rate, which is just an average of the short rates, will smoothen out the volatility in the short rates. And finally, since the risk premium increases with time to maturity, the liquidity premium theory tells us that the yield curve will normally slope upwards, only rarely will it lied flat or slope downwards.

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