The yield to maturity on two-year bonds is 8.5%. The forward rate for the third year is f 3 8% 1% 9%. We obtain the yield to maturity on three-year zeros from

(1 ) (1 ) (1 ) 1.085 1.09 1.2832 3 3

2 2

3 y y f 2 Therefore, y 3 .0867 8.67%. We note that the yield on one-year bonds is 8%, on two-year bonds is 8.5%, and on three-year bonds is 8.67%. The yield curve is upward-sloping due solely to the liquidity premium.

 LO.1