The yield to maturity on 1-year zero-coupon bonds is currently 6%; the YTM on 2-year zeros is 7%. The Treasury plans to issue a 2-year maturity coupon bond, paying coupons once per year with a coupon rate of 8%. The face value of the bond is $100.
a) At what price will the bond sell?
b) What will the yield to maturity on the bond be?
c) If the expectations theory of the yield curve is correct, what is the market expectation of the price that the bond will sell for next year?
d) Recalculate your answer to (c) if you believe in the liquidity preference theory and you believe that the liquidity premium is 2.5%.