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10. It is assumed that one-year interest rates on bonds over next five years are 6.5%, 6.75%, 7.25%, 8.50% and 9.25% and liqu

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Answer #1

Nominal yield as per Expectations theory = ((1 +1 year rate in 1 year)*(1+ 1 year rate in 2 year)*(1+ 1 year rate in 3 year)*(1+ 4 year rate in 4 year)*(1 + 1 year rate in 5 year)^(1/n))-1

(((1+6.5%)*(1+6.75%)*(1+7.25%)*(1+8.5%)*(1+9.25%))^(1/5))-1

=0.0765 or 7.65%

Liquidity premium on 5 year bond = 0.50%

Then Yield on 5 year bond = Nominal yield as per Expectations theory + Liquidity premium

=7.65% +0.50%

=8.15%

So answer is b. 8.15%

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