Assume that a 1- year discount bond (bond A) with a face value of $1,000 is curr

Question

Assume that a 1- year discount bond (bond A) with a face value of $1,000 is currently trading at PV = $938.97, and another 2-year discount bond (bond B) with identical risk features and face value is currently trading at $834.01.

A. Please calculate the next year anticipated price on the bond A according to the Expectations Theory of the Term Structure

B. Please calculate the next year anticipated price of the bond A according to the Liquidity Premium Theory of the Term Structure under assumption that investors require additional 1.5 percentage points premium to consider a 2-year investment, ceteris paribus

Explanation / Answer

Value of one year discount bond = $938.97

According to the expectations theory,long term rates provide an indication of short term rates.Hence an average of the short term rates for the same period would be same as the long term rate.

Basing on this assumption, price of the Bond A would be 938.97+834.01/2 = $886.49.

Answer for question b:

According to liquidity premium theory as the risk averse investors expect more return than average return as explained in the expectation theory of the term structure, since as the holding period of the security increases, so does the risk, hence the investor wants to compensate the risk by way of premium over the average expected return.

In the given case premium mentioned is 1.5% points

Therefore, inorder to consider a two year investment the price of the bond A, price of the bond should be average as computed above multiplied by the premium points = [(938.97+834.01)/2] * 101.5% = $899.79

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