1) Homer Simpson is considering three investment options.Option 1 involves investing in a zero coupon bond for two years.Option 2 involves investing in a five-year zero coupon bond and then selling that bond in two-year's time.Option 3 involves investing in a one year zero coupon bond and then investing in another one year zero coupon bond when the first zero coupon bond matures.Assume for this question that three and five year bonds are illiquid at all times.Which of the following are correct?

i. According to the market segmentation hypothesis, Option 1 would be preferred to Option 3.

ii. According to the liquidity premium hypothesis, Option 2 is riskier than Option 1 because the selling price at t=2 could be very low because three year bonds are illiquid.

iii. According to the pure expectations hypothesis, the actual return from all three strategies is identical.

iv. According to the preferred habitat theory, Option 1 is preferred to Option 2 but Option 2 may be preferred if Homer Simpson believes that the three-year spot rate in two-year's time is less than f(2,5)

v. According to the preferred habitat theory, Option 1 is preferred to Option 3 but Option 3 may be preferred to Option 1 if Homer Simpson believes that the one-year spot rate in one year's time is less than f(1,2).

The correct answer is:

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2) Which of the following are correct?

I. If expected inflation increases, investors will consider selling bonds as the real value of this investment will decrease and bond yields should increase.

II. Reinvestment risk occurs when interest rates decrease so that coupons from a bond are reinvested at a lower rate than originally expected.

III. If interest rates are expected to increase, an investor should consider selling long-maturity bonds and buying short-maturity bonds to decrease portfolio duration.

IV. If the risk of default on a bond already issued by a company is expected to decrease, investors should consider selling that bond, as the discount rate will decrease.

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3) Which of the following are correct?

i. The liquidity premium for a 2-year government bond is higher than the liquidity premium for a 5-year government bond.

ii. The liquidity premium for a 3-year government bond is lower than the liquidity premium for a 3-year corporate bond.

iii. The expected return from holding an illiquid two year zero-coupon bond to maturity is higher than the expected return from buying a liquid one-year zero-coupon bond (and holding it to maturity) followed by investing in another liquid one-year zero coupon bond (and holding it to maturity).

iv. The expected one-year rate in one year's time is lower under the Liquidity Premium Hypothesis than the expected one-year rate in one year's time under the Pure Expectations Hypothesis (assuming that two-year bonds are illiquid and one-year bonds are liquid).

The correct answer is:

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4) Suppose the yield curve is as shown below. Assuming semi-annual compounding, what is f(2,4)?

1 year spot rate: 3.20%

2 year spot rate: 3.35%

3 year spot rate: 4.35%

4 year spot rate: 5.25%