Yield Curve Theories

On July 18, 2018, the U.S. Treasury Resource Center for interest rates reports the

following current (spot) Treasury bond rates:

5-year bond rate =2.75%; 10-year bond rate = 2.87%

a. Under the expectations theory, what is the expected 5-year bond rate (forward

rate) 5 years from now? Based on your answer, what are rates expected to do

(rise/fall/stay the same)? Explain why

Expected 5-year Treasury bond rate 5 years from now = _________________

(Be sure to show your work here).

Rate are expected to ___________ because ________________________

b. For the same above suppose

there is a liquidity premium of 0.20% for a 10-year

bond and 0.10% for a 5-year bond, under the liquidity premium theory (adjusting

for liquidity premiums incorporated in bond rates)

what is the new expected 5-year

bond rate 5 years from now? Based on your answer, what are rates expected to do

(rise/fall/stay the same)? Explain why and why the expected rate under the liquidity

premium theory differs from that of the expectations theory.

Expected Rate with LP __________ Rates Expected to __________________

(Be sure to show your work here).

c. Briefly explain the market segmentation theory (Chapter 2). Suppose the U.S.

Treasury issues a large quantity of short-term 1-year T-bills, under the market

segmentation theory, what would be the effect of this issue on respectively short-

term and long-term interest rates based on the segmentation theory.