Question

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?

Answer 1

(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%