Suppose that today you observe the following interest
rates on bonds with differing times to maturity:
a. Assume that the expectations theory is correct,
so that there is no term premium for a two-year
bond or a three-year bond. Use the information
above to calculate the expected interest rate on a
one-year bond one year from now and the interest
rate on a one-year bond two years from now.
b. Now assume that the liquidity premium theory
is correct and that the term premium on
the two-year bond is 0.25% and the term premium
on the three-year bond is 0.50%. Now
calculate the interest rate on a one-year bond
one year from now and the interest rate on a
one-year bond two years from now.