Based on the U.S. Treasury bond information below, answer the following series o

Question

Based on the U.S. Treasury bond information below, answer the following series of questions Maturity Coupon Rate 3% 4% 3% 0% Bond Price ears 100.000 100.500 98.750 92.000 0.5 1.5 2.0 4 A. [8 points (2 per spot rate)] From the given information, compute the 6-month, 1-year, 1.5-year, and 2-year spot rates. Do not round excessively: use at least 5 decimal places (for example 12.345%). [1 points] Is the term structure inverted, normal, or flat? [1 points] Use the liquidity preference theory to explain the shape of the term structure (your answer to B) B. C.

Explanation / Answer

We will use the bootstrapping method to derive all the spot rates. Assuming semi-annually compounding for Treasury bonds, price is the discounted value of all cash flows.

0.5 year using Bond 1

100 = ((3%/2) + 100)/(1+r1/2) => r1 = 3%

1 year using Bond 2

100.5 = (2/(1+r1/2)) + (102/(1+r2/2)^2) =>r2 = 3.492%

similarly, 1.5 year using Bond 3 => r3 = 3.874%

similarly, 2 year using Bond 4 (zero coupon) => r4 = 4.213%

100/(1+r4/2)^4 = 92

As the rates are increasing, yield curve is normal.

The liquidity preference theory suggests that an investor demands a higher interest rate, or premium, on securities with long-term maturities, which carry greater risk, because all other factors being equal, investors prefer cash or other highly liquid holdings

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