09 Jul The bond market to be in equilibrium
Consider the bond market to be in equilibrium according to the complete theory of the term structure of interest rates. The current interest rate on one-year bonds is 2 percent, and you believe, as does everyone in the market, that in one year the interest rate on one-year bonds will be 3 percent, and in two years, the interest rate on one-year bonds will be 4 percent. That is, using the standard notation, i 0 = 2%, i 1 = 3%, and i 2 = 4%.
Assume that there is no term premium on a one-year bond.
a. According to the expectations theory of the term structure of interest rates, what will the interest rate be today on a two-year bond and a three-year bond? That is, what are i 0 and i 0 ? Page – 3 Suppose the term premium equals 0.75 percent × the number of years to maturity, for the 2- year bond and the 3-year bond.
b. Calculate the interest rate today on the two-year bond and the three-year bond, incorporating the term premium.
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