Assume that a 1- year discount bond (bond A) with a face value of $1,000 is currently trading at PV = $938.97, and another 2-year discount bond (bond B) with identical risk features and face value is currently trading at $834.01.
A) Please calculate the next year anticipated price on the bond A according to the Expectations Theory of the Term Structure
B) Please calculate the next year anticipated price of the bond A according to the Liquidity Premium Theory of the Term Structure under assumption that investors require additional 1.5 percentage point’s premium to consider a 2-year investment, ceteris paribus.
C) In your own words, explain the major differences between the two Theories.