3. Assume that the current 1-year interest rate is 4% and we know that market participants expect the 1-year rate to be 2.5% starting a year from now, 2.7% starting in 2 years and 4% starting in 3 years from now.

1. Calculate long-term interest rates.

2. Draw the yield curve for bonds up to 4 years to maturity.

3. Assume now that people in addition want a small premium for holding on to longer-term bonds rather than short-term. Add this liquidity premium to your graph.

4. Go to wsj.com. Follow the link to Markets Bonds and rates. Scroll down and look at the yield curve. What about is the current interest rate on a 1-year bond and on a 5-year bond? What does this tell us about what people expect from the 1-year rate in about 5 years?