On January 17, 2018, the U.S. Treasury Resource Center for interest rates reports the following current (spot) Treasury bond rates:
5-year bond rate = 2.25% and
10-year bond rate = 2.46%
1. Under the expectations theory,
(a) what is the expected 5-year bond rate (forward rate) 5 years from now?
(b) Based on your answer, what are rates expected to do (rise/fall/stay the same)? Explain why
2. Suppose there is a liquidity premium of 0.20% for a 10-year bond and 0.10% for a 5-year bond, under the liquidity premium theory (adjusting for liquidity premiums incorporated in bond rates)
(a) What is the new expected 5-year bond rate 5 years from now?
(b) Based on your answer, what are rates expected to do (rise/fall/stay the same)?
(c) Explain why and why the expected rate under the liquidity premium theory differs from that of the expectations theory.
3. Market Segmentation Theory
(a) Briefly explain the market segmentation theory.
(b) Suppose the U.S. Treasury issues a large quantity of long-term 10-year Treasury bonds, under the market segmentation theory, what would be the effect of this issue on respectively short-term and long-term interest rates based on the segmentation theory.