Question: Assume that the current 1-year interest rate is 1%. It is expected that the 1-year rate will rise to 3% next year, and then to 5% the following year. The market currently puts a liquidity premium of 1% on 2-year bonds and 3% 3-year bonds.
a) Using the Liquidity Premium Theory of Term Structure, what should be the current 2-year interest rate? What about the current 3-year interest rate?
b) Draw the yield curve associated with your results in part (a)