Question

# Suppose in the Wall Street Journal you see the following current (spot) interest rates for Treasury...

Suppose in the Wall Street Journal you see the following current (spot) interest rates for Treasury bonds with an upward sloping yield curve:

5-year bond rate =1.45%; 10-year bond rate = 2.13%

a. Under the expectations theory, what is the expected 5-year bond rate (forward rate) 5 years from now? Based on your answer, what are rates expected to do (rise/fall/stay the same)? Explain why

Expected 5-year bond rate 5 years from now = _________________

(Be sure to show your work here).

Rate are expected to ___________ because ________________________

b. For the same aboveif there is a liquidity premium of 0.10% for a 5-year bond and 0.20% for a 10-year bond, under the liquidity premium theory (adjusting for liquidity premiums incorporated in bond rates) what is the new expected 5-year bond rate 5 years from now? Based on your answer, what are rates expected to do (rise/fall/stay the same)? Explain why.

Expected Rate with LP __________ Rates Expected to __________________

(Be sure to show your work here).

c. Explain how interest rates are determined under the market segmentation theory What is the flaw in this theory?

(A)

5-Year bond rate = 1.45%

10 year Bond rate = 2.13%

Let 5 Year Expected Forward rate = X

Hence (1+0.0213)^10 = (1+0.145)^5* (1+X)^5

=>X = 0.0281455791 OR 2.815%

Rates are expected to rise in 5years from now.

(B)

5-Year bond rate = 1.45%

10 year Bond rate = 2.13%

Liquidity premium on 5 yaer Bond= 0.10%

Liquidity premium on 10 year Bond= 0.20%

5 Year Expected Forward rate = X

Hence ,

(1+0.0213-0.002)^10 = (1+0.0145-0.001)^5* (1+X)^5

=>X = 0.0251331920 OR 2.51%

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