Suppose that the interest rate on a one year bond is 7 percent today and the int

Question

Suppose that the interest rate on a one year bond is 7 percent today and the intrest rates are exected on one yea bonds in the future are 6 percent in one year, 5 percent in two years, and 4 percent in three years.

a) According tothe expecations theory of the term structure, what arethe inteest rate today on a two year bond, a three year bond, and a for year bond?

b) If the term premium is equal to half a percent times the number of years to maturity of a bond for times to maturity of two, three, and four years, what are the interest rates today on a two year bond, a three year bond, and a four year bond

Explanation / Answer

a) Two year bond : (7+6)/2 = 6.5% Three year bond: (7+6+5)/3 = 6% Four year bond : (7+6+5+4)/4 = 5.5% b) Two year: 1/2 = 50% Three year : 1/3 = 33.3% Four year : 1/4 = 25%

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