3 Liquidity premium theory You are given a set of five bonds whose cash flows and prices are given as follows. Note that their debt to maturity is different from 1 to 5 years. 3 3 3 3 103 100 3.5 3.5 3.5 103.5 0 100 Cash Flow = 4 4 104 0 0 and Current Price = 100 4.5 104.5 0 0 0 100 105 0 0 0 0 100 1. Calculate the yield to maturity for the five bonds. 2. Draw the yield curve. 3. Assume that the liquidity premium for all five years is given in the following table. Calculate the one-year interest rates in year 1, 2, 3, 4 and 5 based on the liquidity premium theory. Year 1 2 3 4 5 Liquidity Premium 0% 0.5% 1% 1.5% 2% 4. What do you observe in the future short-term interest rates? How does this pattern imply the possibility of entering a recession