ASUME that interest rate on one-year bond is 2%. You can observe that the intere

Question

ASUME that interest rate on one-year bond is 2%. You can observe that the interest rate on 2-year bond is 2.6%. Assume there is no liquidity premium and the interest rates are determined according to expectation hypothesis of the yield curve.

a. Based on the interest rates above, what is the expected 1-year interest rate, starting one year from today?

b. If the interest rate on 3-year bond is 3%., what is expected 1-year interest rate starting 2 years from today?

c. Draw the yield curve for the next three years.

d. Is the yield curve for the next three years upward sloping or downward sloping? Explain why

Explanation / Answer

a) 1.026^2 = 1.02*(1+r)

by solving above eqn, r = 3.203

b) 1.03^3 = (1.026^2)*(1+r)

r = ((1.03^3)/1.026^2)-1 = 3.80

d) it is upward sloping as r is increasing

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