Currently, Yields to Maturity on 1-year and 2-year US Treasury securties are .60

Question

Currently, Yields to Maturity on 1-year and 2-year US Treasury securties are .602% and .852%. You can assume that for simplification purposes there are no coupon payments on these bonds and the ytm is entirely due to the difference in face value and current market price of these securities.

a.) If financial market investors were risk neutral, what would this data imply about the market expectations of the yield on 1 year bonds 1 year from now? Show your calculations.

b) Given that financial market investors are risk averse, do you think actual market expectations differ slightly from your answer to (a). If so, how? Explain your answer.

Explanation / Answer

a)expectations of the yield on 1 year bonds 1 year from now

= ((1+Yields to Maturity on 2-year Treasury securties)/(1+Yields to Maturity on 1-year Treasury securties))-1

= ((1+0.852%)/(1+0.602%))-1

=(1.00852/1.00602)-1

=1.002485-1

=0.002485

=0.2485%

Thus expectations of the yield on 1 year bonds 1 year from now is 0.2485%.

b) If investors are risk averse then actual market expectations should differ slightly from answer to a).The investors demands risk premium on the yield on 1 year bonds 1 year from now since the investors are risk averse they demand some premium over and above the risk neutral yield for holding the security as they face the interest rate risk and liquidity risks. Therefore they shall demand risk averse yield of =risk neutral yield+risk premium different from risk neutral yield of 0.2485%.

Related Questions

Navigate

• Browse (All)
• Browse C
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.