a. Consider the expectations theory (of the term structure) with a term premium.

Question

a. Consider the expectations theory (of the term structure) with a term premium. What is the interest rate on a 5-year bond today if the term premium for a 5-year bond is 2% and 1-year interest rates are expected to remain constant at their current level of 3 percent? No credit if you do not show your work.

b. What is the term premium for a 6-period bond if the interest rate on the 6-period bond today is 10 percent and 1-period interest rates are expected to rise by 2% each year from their current level of 4%? No credit if you do not show your work.

Explanation / Answer

Answer for b :

Since it is given as term premium for a 6 period bond where the interest rate is 10%.

Therefore for example :

If a bond is priced at $100 with a coupon interest rate of 2% then the premium at the end of the bond or the total interest earn after 6 years would be $100*6*2/100=$12.

Therefore you want to find the future value of a bond for 6 years at 10 % interest rate which is FV of bond= PVIF(6years, 10%).

PVIF (6 years,10%)= 1.77156

therefore the future value = 100*1.77156 = 177.156 the bond value

Henceforth the premium would be (177.156-100)/100=77.56%

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