Part 1

Using your knowledge of zero coupon/spot rate methods and the information provided, calculate the missing theoretical spot rates in the table below:(5 marks)

YearYield to MaturityCouponTotal PriceSpot Rate

0.54.00%098.0394.00%

1.04.25%095.9234.25%

1.55.70%12%108.936?

2.05.90%6%100.186?

Assume all rates quoted are from Australian Commonwealth Government debt issues, and use Australian Financial markets bond pricing conventions to calculate your answers.

Part 2

Two hypotheses that have been put forward to explain different shapes of the term structure of interest rates are the Pure Expectations Hypothesis and the Liquidity Premium Hypothesis. These hypotheses differ in their treatment of the term premium.

Explain these hypotheses and how and why they differ in their treatment of the term premium.