1.The yield of a one-year bond this year equals to 6.5%, and people expect the yield of a one-year bond to remain the same on the second year but fall to 5% on the third year. Also, people also require a 0.25% term premium for each additional year of bond maturity.
a. Calculate the yield of a two-year bond and a three-year bond according to the theory of liquidity premium. Compare the yields of the three-year bond, two-year bond, and one-year bond, what does it tell you about the shape of the yield curve?
b. Calculate the yield of a two-year bond and a three-year bond according to the expectations theory. Compare the yields of the three-year bond, two-year bond, and one-year bond, what does it tell you about the shape of the yield curve?