Suppose the current 1-year spot rate r1=7% and the market has an expectation as:

 Please draw the yield curve under expectation theory and the liquidity premium theory, assuming a term of liquidity premium at 3%. Explain what generates the differences between two yield curves.

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E(r.¹)) = 5% E(r.¹)) = 5%

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Under the Expectation Theory of the term structure of interest rates the yield curve is derived based on the markets expectations of future shortterm ... View the full answer