The yields to maturity of a one-year, two-year and three-year government bonds today are

respectively 1.25%, 1.5% and 1.75% per annum.

2.1. Assume the pure expectations theory holds. What are the expected one-year bond yield for the

next two years? Show your calculations clearly.

2.2. Now assume the liquidity premium theory is correct instead and further assume we know the

risk premiums for the two-year bond and three-year bond are respectively 0.25% and 0.5%

respectively. What are the expected one-year bond yield for the next two years? Show your

calculations clearly.

2.3. If the bond market is efficient and bond investors form expectations rationally, then a normal

yield curve implies that the market expects the short term interest rate, say, one-year bond yield to

go up in subsequent years. True, false or uncertain. Explain