Q1. Suppose that the interest rate on one-year bonds is 4 percent today, and is expected to be 6 percent one year from now and 7 percent two years from now and 7.5 percent three years from now.Use the expectations hypothesis to compute and to graph the yield curve for the next three years.
Q2.You have $1,000 to invest over an investment horizon of three years.The bond market offers various options.You can buy (i) a sequence of three one-year bonds; (ii) a three-year bond; or (iii) a two-year bond followed by a one-year bond. The current yield curve tells you that the one-year, two-year, and three-year yields to maturity are 3.5 percent, 4.0 percent, and 4.5 percent respectively.You expect that one-year interest rates will be 4 percent next year and 5 percent the year after that.Assuming annual compounding, compute the return on each of the three investments, and discuss which one you would choose.
Q3.You and a friend are reading The Wall Street Journal and notice that the Treasury yield curve is slightly upward sloping.Your friend comments that all looks well for the economy but you are concerned that the economy is heading for trouble.Assuming you are both believers in the liquidity premium theory, what might account for your difference of opinion?
Q4. What is the equivalent tax exempt bond yield for a taxable bond with an 8% yield and a bondholder in a 30% marginal tax rate?
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