Question 5 [10 marks]

a)Suppose the one-year interest rates over the next five years are expected to be 4%, 5.6%, 7.3%, 10.1% and 13%. Investors' preferences for holding short-term bonds have the liquidity premiums for one-year to five-year bonds as 0%, 0.10%, 0.24%, 0.30% and 0.49%, respectively. Calculate the interest rates on a two-year bond and a five-year bond.

[6 marks]

b)The yield on a corporate bond is 11.5%, and it is currently selling at par. The marginal tax rate is 25%. A par value municipal bond with coupon rate of 6.45% is available. Propose the security which is better to buy.

[4 marks]