Question 24:
a. Path of one-year rates: 3.75%, 3.93%, 4.49%, 4.84%, 5.14%
1-year rate: 3.75%
2-year rate: (3.75% + 3.93%) / 2 = 3.84%
3-year rate: (3.75% + 3.93% + 4.49%) / 3 = 4.06%
4-year rate: (3.75% + 3.93% + 4.49% + 4.84%) / 4 = 4.25%
5-year rate: (3.75% + 3.93% + 4.49% + 4.84% + 5.14%) / 5 = 4.43%
Since the rates consistently increase with maturity, this is an upward-sloping
yield curve.
b. Path of one-year rates: 3.75%, 2.8%, 2.2%, 2.6%, 3.5%
1-year rate: 3.75%
2-year rate: (3.75% + 2.8%) / 2 = 3.28%
3-year rate: (3.75% + 2.8% + 2.2%) / 3 = 2.92%
4-year rate: (3.75% + 2.8% + 2.2% + 2.6%) / 4 = 2.84%
5-year rate: (3.75% + 2.8% + 2.2% + 2.6% + 3.5%) / 5 = 2.97%
The long-term rates are lower than the short-term rate (3.75%). This is an
inverted or downward-sloping yield curve.
If investors prefer short-term bonds, issuers must offer an extra premium
(a positive liquidity or term premium) to persuade investors to hold longer
maturities. Concretely, add a positive liquidity/term premium that
typically increases with maturity to the pure expectations averages. As a
result: long-term yields become higher than the pure averages; the yield
curve becomes steeper (more upward tilt) relative to the expectations-
only curve. Consequences for our two paths:
o For path a (already upward): the curve becomes even more
steeply upward.
o For path b (inverted/flat): adding an increasing positive
premium to long maturities can flatten or even eliminate the
inversion — it may make the long end higher than the
expectations curve, possibly producing a flatter or slightly
upward curve depending on premium size.
Question 25:
Multiyear Bond Rate = Average of Expected One-Year Rates + Liquidity
Premium
Liquidity Premium = Multiyear Bond Rate - Average of Expected One-Year
Rates
Averages of one-year rates:
1-yr avg = 0.20%
2-yr avg = (0.20 + 0.30)/2 = 0.25%
3-yr avg = (0.20 + 0.30 + 0.40)/3 = 0.30%
4-yr avg = (0.20 + 0.30 + 0.40 + 0.60)/4 = 0.375%
5-yr avg = (0.20 + 0.30 + 0.40 + 0.60 + 0.70)/5 = 0.44%
Liquidity premiums (multiyear yield − average):
1-year LP = 0.50% − 0.20% = 0.30 percentage points (30 bps)
2-year LP = 0.80% − 0.25% = 0.55 pp (55 bps)
3-year LP = 0.95% − 0.30% = 0.65 pp (65 bps)
4-year LP = 1.00% − 0.375% = 0.625 pp (62.5 bps)
5-year LP = 1.10% − 0.44% = 0.66 pp (66 bps)