Consider two types of bonds: a 2-year bond and a 3-year bond.

Both types have face value equal to $100.

The current risk free one-year interest rate is 2%.

The risk premium is 5%.

• What should be the current price for the 2-year bond? What should be the expected price for the 2-year bond next year? What should be the current price for the 3-year bond?

The market expects the risk free one-year interest rate to rise to 3% next year and 4% the year after.