Q1. Suppose that
the interest rate on one-year bonds is 4 percent today and is expected to be 6
percent one year from now and 7 percent two years from now and 7.5 percent
three years from now.Use the expectations
hypothesis to compute and to graph the yield curve for the next three years.Q2.You have
$1000 to invest over an investment horizon of three years.The bond market offers various options.You can buy (i) a sequence of three one-year
bonds; (ii) a three-year bond; or (iii) a two-year bond followed by a one-year
bond. The current yield curve tells you that the one-year two-year and
three-year yields to maturity are 3.5 percent 4.0 percent and 4.5 percent
respectively.You expect that one-year
interest rates will be 4 percent next year and 5 percent the year after
that.Assuming annual compounding
compute the return on each of the three investments and discuss which one you
would choose.Q3.You and a
friend are reading The Wall Street
Journal and notice that the Treasury yield curve is slightly upward
sloping.Your friend comments that all
looks well for the economy but you are concerned that the economy is heading
for trouble.Assuming you are both
believers in the liquidity premium theory what might account for your
difference of opinion?Q4. What is the
equivalent tax exempt bond yield for a taxable bond with an 8% yield and a
bondholder in a 30% marginal tax rate?