Question

(b) (i) Short term (one year) interest rates over the next 6 years will be 0.5%, 0.6%, 0.7%,
0.76%, 0.80% and 0.84%. Using the expectation theory, what will be the interest rates
on a three-year bond? [2 marks]

(ii) Predict the one-year interest rate three years from today if interest rates are 4%,
4.5%, 4.75% and 5% for bonds with one to four years to maturity and respectively
liquidity premiums are 0%, 0.1% , 0.15% and 0.2%. [3 marks]

(c) Explain THREE (3) conventional monetary policy tools used by the Central bank
of a country to control the money supply and interest rates in the financial markets.

Answer 1

b)

i) Three year rate (r) is given by

(1+r)^3= 1.005*1.006*1.007

=> r= 0.006 or 0.6%

ii) Forward rate for 1 year after 3 years

= (1+4 year bond interest rate)^4/(1+3 year bond interest rate)^3- 1

=1.05^4/1.0475^3-1

=0.0575359

or 5.7536%

iii) Monetary policy tools:

a) Open market operations : The Central bank can buy or sell Treasury bills/bonds in the open market to increase or decrease money supply

b) Reserve Requirements : The Central bank can change the reserve requirements and increase or decrease the money supply through banks

c) Changing the key rates : Central bank can change the key interest rates . Increasing the interest rates puts the money in banks and decreasing the interest rates increases the money supply