Assume the yield of one-year bonds is currently equal to 2%, is expected by equal to 3% a year from now and is expected to be equal to 4% two years from now.
a. if the annual yield on a 2-year bond is currently 3%, what is the risk premium (or liquidity premium) for the 2-year bond relative to the one-year bond? Hint: the first step in answering this is to compute the 2-year bond yield according to the expectations theory of the term structure.
b. if the annual yield on a 3-year bond is currently 5%, what is the risk premium (or liquidity premium) for the 3-year bond relative to the one-year bond? Hint: the first step in answering this is to compute the 3-year bond yield according to the expectations theory of the term structure.