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Computing the expected interest rates

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.

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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