Question

A) Suppose that the one-year interest rates over the next five years are expected to be

5%, 6%, 7%, 8% and 9%, while investors preferences for holding short-term bonds

means that liquidity premiums for one-to five-year bonds are 0%, 0.25%, 0.5%,

0.75% and 1% respectively. What would be the interest rate on the two-year and five-year

bond under the Liquidity Premium theory? [5 marks]

B) With aid of a diagram, explain how the equilibrium interest rate is attained in the

supply and demand for bonds. [10 marks]

C) State and explain the factors that affect the demand and supply of bonds.

[5 marks]

D) With the aid of a diagram, explain the "Fisher Effect" in the bond market.

[10 marks]