Suppose that:1) The interest on a one-year bond today is 3%;2) The interest on a one-year bond starting one year from now is expected to be 4% per year;3) The interest on a one-year bond starting two years from now is expected to be 5% per year;4) The risk premium on a two-year bond is 0.5%; and5) The risk premium on a three-year bond is 1.0%.Use that information to answer the following questions.a)According to the expectations theory, what is the interest rate today on a two-year bond? Show your work.b)According to the expectations theory, what is the interest rate today on a three-year bond? Show your work.c)Plot the yield curve.
What will be an ideal response?
| a) | (3% + 4%)/2 + 0.5% = 4.0% |
| b) | (3% + 4% + 5%)/3 + 1.0% = 5.0% |
| c) | plot 3 points with 1, 2, and 3 years to maturity vs. yields of 3%, 4%, and 5%. |
Economics
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