Suppose todays yield curve is given:

a) What are the current interest rates on 1-year, 2-year and 3-year bonds?

b) Please calculate expected interest rates on 1-year bond next year and two years from now using expectations theory. Are they expected to grow, decrease or stay the same?

c) Now suppose you know that 2-year term premium is 0.6% and 3-year term premium is 0.8%. Please recalculate expected interest rates on 1-year bond next year and two years from now under liquidity premium theory. Again, are they expected to grow, decrease or stay the same? Compare this conclusion to the one in part (b) and explain the difference.

Yield Curve 3.00% 2.60% 2.40% 2.50% 2.20% 2.00% 1.50% 1.00% 1 2 3 Yield Curve 3.00% 2.60% 2.40% 2.50% 2.20% 2.00% 1.50% 1.00% 1 2 3