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Homework 2_solution

# Homework 2_solution - Homework 2 E305 Money and Banking...

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Answer: According to the liquidity premium theory, the two-year yield (i 2,t ) is an average of this year’s and next year’s one-year yields (i 1,t +i e 1, t+1 ) plus a risk premium (rp) to compensate for the inflation and interest-rate risk associated with the longer maturity. i 2,t = (i 1,t +i e 1, t+1 )/2 +rp We can see from the formula, if the current one-and two-year yields are the same and there is a risk premium included in the two-year yield, then next year’s one-year yield must be lower than this year’s. 4. Problem 7.7 You have \$1000 to invest over an investment horizon of 3 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.
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