Question
Assume that the current yield curve is as follows: Maturity (years) Yield 1 4.00% 2 5.50% 3 6.10% Note: All yields above are nominal annual
Assume that the current yield curve is as follows:
Maturity (years) | Yield |
1 | 4.00% |
2 | 5.50% |
3 | 6.10% |
Note: All yields above are nominal annual rates but we assume all bonds pay interest semi-annually.
Answer true or false to the following statements, making sure to explain your answers carefully and performing relevant calculations where necessary:
(i) (1 mark) Assume the Liquidity Premium Hypothesis (LPH) holds. If the expected one-year rate in two years time is 7.00%, then the liquidity premium for three-year bonds is 0.305%.
(ii) (2 marks) Assume the yield curve is as shown in the table above and that the Preferred Habitat Theory (PHT) holds. If the expected one-year rate in two-years time is 7.00%, then the risk premium is negative because demand for three-year bonds is too high relative to demand for two-year bonds.
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