Suppose we are only considering zero-coupon bonds for this problem. The current one-year interest rate is 8%. Investors believe that the interest rate on one-year bonds next year will rise to 9%, and the interest rate on one-year bonds the year after next year will further rise to 10%.

a) What do these beliefs imply about the YTM on two-year and three-year bonds issued today?

b) What do these beliefs imply about the YTM on two-year bonds issued after one year?

c) What is the expected rate of return over the first year for the three-year bond? Plot the three YTM's (i.e., YTM for the one-year, two-year and three-year bond).

d) Briefly describe the shape of the yield curve. e) Besides the EH (expectation hypothesis), does there exist some other theory that explains the shape of the yield curve? Briefly explain.

Answer rating: 100% (QA)

a The beliefs imply that the yield to maturity YTM on twoyear and threeyear bonds issued today will be lower than the expected future interest rates S... View the full answer