Question

6. Suppose that 1-year bonds currently offer a nominal yield to maturity of 4% (110 = 0.04), otherwise comparable 2-year bonds currently offer a yield to maturity of 3% (120 = 0.03), and 3 year bonds currently offer a yield to maturity of 2.5% (13,0 = 0.025). a. Draw the yield curve. b. Based on the Expectations Theory of Term Structure, what do investors expect the yield to be on 1 year bonds next year (i.e. - what is i11)? c. What do investors expect the yield to be on 1 year bonds in two years (11.2 =?)? d. What do investors expect the yield to be on 2 year bonds next year (isi =?)? e. Draw next year's (time 1) expected yield curve.

Answer 1

Term	Yield
1	4%
2	3%
3	2.50%

Sum of Yield Total 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% - Total Term

Forward rate formula =

fn = (1 + ytmn)"/(1+ytmn-1)n-1-1

YTM = yield to maturity

f = forward rate

n = term

Term	Yield	Forward rate
1	4%	4%
2	3%	2.01%
3	2.50%	1.51%

b) Investors can expect the yield on 1 year bonds next year to be 2.01%

c) Investors can expect the yield on 1 year bonds in 2 years to be 1.51%

d) Investors expectation of yield on 2 year bonds next year can be ascetained by

{(1.025)^3 / 1.04^1} - 1 = 1.035472-1 = 3.55%

d) Year 2's expected yield curve

Term	Expected Yield
1	2.01%
2	3.55%

Sum of Yield Total 0.04 0.035 0.03 0.025 0.02 0.015 0.01 0.005 - Total Term