Question

Analysts predict that short-term interest rates over the next 4 years will be as follows: 5.5%, 4%, 1.1%, and 10%, respectively. According to expectations theory, the yield on a discount bond with a three year maturity will be ____ and yield on bond with a four year maturity will be ____.

Group of answer choices

3.05%; 5.55%

3.05%; 5.15%

3.53%; 5.55%

3.53%; 5.15%

Consider the same short-term interest rates as in problem 4 above. If the yield on a discount bond that matures in four years is 6.4%, then according to liquidity premium theory, the premium attached to the 4 year discount bond is

Group of answer choices

1.25%

1.15%

0.85%

0.55%

Answer 1

1.
Yield on a discount bond with a three year maturity = (5.5% + 4% + 1.1%) / 3
= 10.6% / 3
= 3.53%

Yield on bond with a four year maturity = (5.5% + 4% + 1.1% + 10) / 4
= 20.6% / 4
= 5.15%

According to expectations theory, the yield on a discount bond with a three year maturity will be 3.53% and yield on bond with a four year maturity will be 5.15%.

2.
Yield on a discount bond with a three year maturity = ((5.5% + 4% + 1.1% + 10) / 4) + Premium

6.4% = 5.15% + Premium

Premium = 6.4% - 5.15%

Premium = 1.25%