Question 2

(I)what do you mean by the term structure of interest rates? Explain with a suitable example.5 marks

(II)How do you defineYield Curve? What is the implications of an inverted yieldcurve?5 marks

(III) 15 marks. Draw the yield curve described as follows:

Interest rates: 1% in year 1; 1.5% in year 2; 2% in year 3; 3.5% in year 4

. Term premiums: 0.5% for a one-year bond, rising by 0.25% for each additional year of maturity.

What does this yield curve suggest over the short to medium-term economic outlook among market participants?

You need to illustrate and explain. Precisely, you need to label the graph, identify the points (and show how you computed all the points), name the type of the curve and prove your point.