A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and also the following year. The two-year term premium is 0.35% while the three-year term premium is 0.55%. (Show your work.)
a. According to the expectation theory, calculate the interest rate on a two-year bond and the interest rate on a three-year bond. What does it tell you about the shape of the yield curve?
According to the preferred habitat theory, calculate the interest rate on a two-year bond and the interest rate on a three-year bond. What does it tell you about the shape of the yield curve?