Consider the following information about the yield curve:

Overnight: 1%

1 year: 2.5%

2 years: 3.5%

3 years: 4.25%

4 years: 5%

Assuming that there is no premium on the overnight interest rate and that the interest rate premium increases by 0.5 percentage points every year, what is the path of expected interest rates?

a.

Overnight: 1%

1 year: 1.5%

2 years: 2.5%

3 years: 3.25%

4 years: 4%

b.

Overnight: 1%

1 year: 2%

2 years: 3%

3 years: 3.75%

4 years: 4.5%

c.

Overnight: 1%

1 year: 2%

2 years: 2.5%

3 years: 2.75%

4 years: 3%

d.

Overnight: 1%

1 year: 1.5%

2 years: 2%

3 years: 2.5%

4 years: 3%

pur-new-sol

Answer:

Due to increase in interest rate premium,the path of expected interest rate shall be:

1 year=2.5-0.5=2%

2 year=3.5-0.5=3%

3 year=4.25-0.5=3.75%

4=5%-0.5=4.5%

Thus correct answer is option B.

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