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    Computing the expected interest rates

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    1. Yearly rates are 4%, 5%, 6%, 7%, and 8% for the next five years. Please compute and explain the expected interest rate for both the three and four-year bonds if we show the liquidity premiums to be 1.25%, 1%, .75%, .5%, and 0%.

    2. Yearly rates are 4%, 5%, 6%, 7%, and 8% for the next five years. Please compute and explain the expected interest rate for both the three and four-year bonds during the period.

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    Solution Preview

    1.

    Yearly rate for year 1=is1=4%
    Yearly rate for year 2=is2=5%
    Yearly rate for year 3=is3=6%
    Yearly rate for year 4=is4=7%
    Yearly rate for year 5=is5=8%

    Expected interest rate for 3-year bond=ie3=?
    Pure expectation theory suggests that
    (1+ie3)^3=(1+is1)*(1+is2)*(1+is3)
    (1+ie3)^3=(1+4%)*(1+5%)*(1+6%) =1.15752
    ie3=(1.15752)^(1/3)-1=5.00%
    Liquidity premium for three year=ilp3=0.75%
    Market expectation theory in combination ...

    Solution Summary

    Solution describes the methodology to calculate the expected interest rate for the given three and four year bonds.

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