Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates. You observe the following interest rates available today on bonds with differing times to maturity. (You may ignore transactions costs.)
Time to maturity
Yield to maturity
1 year
5.0%
2 years
7.0%
3 years
7.5%
The term premium for the two-year bond is the extra yield to maturity paid on a two-year bond compared with buying two separate one-year bonds (one today and another after one year). You believe that the term premium on the two-year bond is 0.5 percent.The term premium for the three-year bond is the extra yield to maturity paid on a three-year bond compared with buying three separate one-year bonds (one today, another after one year, and another after two years). You believe that the term premium on the three-year bond is 1.0 percent.Given your beliefs about the term premiums on two-year and three-year bonds, calculate the interest rates on one-year bonds that you expect to prevail one year from now and two years from now. In other words, what do you expect to be the yield to maturity on a one-year bond one year from now and what do you expect to be the yield to maturity on a one-year bond two years from now? Explain and show all your work.
What will be an ideal response?
The term premium implies that
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