Suppose that the yield curve shows that the one-year bond yield is 6 percent, th

Question

Suppose that the yield curve shows that the one-year bond yield is 6 percent, the two-year yield is 5 percent, and the three-year yield is 5 percent. Assume that the risk premium on the one-year bond is zero, the risk premium on the two-year bond is 1 percent, and the risk premium on the three-year bond is 2 percent.

a. What are the expected one-year interest rates next year and the following year?

The expected one-year interest rate next year = %

The expected one-year interest rate the following year = %

b. If the risk premiums were all zero, as in the Expectations Hypothesis, what would the slope of the yield curve be?

The slope of the yield curve would be (Click to select)downward slopingflatupward slopingvertical

Explanation / Answer

a) The expected one year interest rate next year

                                      bond yield for one year next year = 5%

                                                      Risk premium give      = 1%

                                Expected one year interest rate next year = 6% (5+1)

    The expected one year interest rate the following year :

                                 Bond yield expected = 5%

                                   Risk premium = 2%

                           Interest rate = 7% (5+2)

b) Calculation of slope of the yield curve :

                    Assuming all risk premiums are zero, The slope of yield curve would be down ward sloping ,Since the bond yield was decreasing from year 1 to year 2 however it was same in year 2 and year3 but since there was no risk premium it's value would be much lower compared to 2nd year yield even though yielding same return in both years. Answer is Downward sloping.

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