Question $3$

Suppose that the current yield for a $1-$year bond is $2$ percent and it is expected that subsequent $1-$

year rates will rise to $4$ percent, $6$ percent and $10$ percent, respectively. Suppose that investors

demand liquidity premium of $1$ percent, $2$ percent and $3$ percent on $1-$year bond, $2-$year bond and

$3-$year bond, respectively introduce the idea of a liquidity premium

$($i$)$ Why liquidity premium? Is this a typical liquidity premium pattern? Briefly explain.

$($ii$)$ Calculate the current yield on a $2-$year long$-$term government bond.

$($iii$)$ Calculate the current yield on a $3-$year long$-$term government bond

$($iv$)$ Calculate the current yield on a $4-$year long$-$term government bond

$($v$)$ On the same graph, draw the yield curve in question $2($v$)$ and the yield curve for this

question. Comment on the relationship between the two yield curves.