Question: Problem 1 (15 marks) Bond # 1 2 3 4 1 - year strip bond 2- year strip bond 2-year 3% coupon bond 2-year 4%

Problem 1 (15 marks) Bond # 1 2 3 4 1 - year strip bond 2- year strip bond 2-year 3% coupon bond 2-year 4% coupon bond Purchase Price for the bond) 975 ? ? ? Year 1 cash flow 1000 0 30 40 Year 2 cash flow 0 1000 1030 1070 Yield to Maturity ? ? 3.50% ?

1. Fill in the missing pieces from the following table using the Law of One Price. Assume all these bonds have the same risk, the yield curve is flat, and any coupon payments are paid annually.

2. If the expectations theory of the yield curve is correct, what is the market expectation of the price that bond #3 will sell for next year?

3. If the liquidity preference theory is correct and you believe that the liquidity premium is 0.5 percent, what is the market expectation of the price that bond #4 will sell for next year?

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