4. The table below shows current and expected future one-year interest rates, as well as current interest rates on n-year bonds

Year One-year Bond Rate N-Year Bond Rate Liquidity premium

1 2% 2% ___0%___

2 3% 3% _0.5%___

3 4% 5% _2%__

4 6% 6% _2.25%_

5 7% 8% _3.6%__

1 Assume the expectation theory of the term structure and calculate interest rates in the term structure for maturities of one to five years.

2 Draw the yield curve for the next four years.

3 Is the yield curve for the next four years upward sloping or downward sloping? Explain why

4 What might the yield curve today indicate about future interest rates?

5 What might the yield curve today indicate about future economic activity? Explain why?

6 What might the yield curve indicate about the markets prediction for inflation rate in the next four years?

7 Calculate the liquidity premium for each n-year bond

8 What does the liquidity premium stay for?

9 Compare the liquidity premium in 2-year bond and 5-year bond. Why is the liquidity premium on 2-year bond lower than the liquidity premium on 5-year bond?