QUESTION 8: YIELD CURVE STRATEGIES [Total = 3 MARKS]

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 interestsemi-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 year's 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-year's 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.