question archive Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates
Consider the bond market to be in equilibrium according to our complete theory of the term structure of interest rates
Subject:FinancePrice:2.86 Bought3
Consider the bond market to be in equilibrium according to our complete theory of the term structure of
interest rates. The current interest rate on one-year bonds is 3.0 percent, and you believe, as does everyone in
the market, that in one year the interest rate on one-year bonds will be 3.5 percent. Assume that there is no
term premium on a one-year bond. Suppose the term premium for the two-year bond is 1.5 percent. The
interest rate today on the two-year bond is
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Rate of Interest for 2 year bond without term premium = [ (1.03)*(1.035) ]^(1/2) -1
= 0.0325
= 3.25%
Rate of Interest for 2 year bond with term premium = 3.25% + (2*1.5%)
= 0.0325 + (2*0.015)
=0.0625
=6.25%
