Question

One year interest rate is 1.58%. Two years rate is 1.68%. three years rate is 1.70%. five years rate is 1.74%.

Use the pure expectations theory to find the interest rate expected on a two-year bond one year from now?

If the investors attach liquidity premiums of 0.002, 0.0015 and 0.0016 to the one-, two- and three-year bonds what would be the interest rate on a two-year security?

Answer 1

According to pure expectations theory of interest rates,

The investment is worth the same at the end of two years --as if the investor invested in 1yr. Security receiving 1.58% over the first year & x% in the 2nd yr.

so, Interest rate expected on a two-year bond one year from now will be:

(1.0158)*(1+x)=(1.0168)*(1.0168)

or x=(1.0168^2/1.0158)-1 =

0.017801

1.78%

If the investors attach liquidity premiums

interest rate on the two-year security will be

1.78%+0.002=

1.98%