Subject: Business / Finance
3. Following are prices (percent of face value) of U.S. Treasury STRIPS (zero-coupon bonds) from trading on April 11, 2014:
10-year 74.526a. Calculate the yield to maturity for each bond and graph the U.S. Treasury zero coupon bond yield curve.
b. Calculate the implied forward rates for years 2 to 10 and graph the implied forward rates.
c. Under the expectations hypothesis, what is the relationship between the forward rates implied by the yield curve and expected future short-term interest rates? What can you say about the path of future expected short-term interest rates on April 11, 2014 under the expectations hypothesis? If real yields are expected to be constant, what can you say about market expectations of future inflation on April 11, 2014 under the expectations hypothesis?
d. Does the expectations hypothesis support the following statement: Given the 289 basis point spread between the yield on the 10-year zero and the 1-year zero, a portfolio of 10-years zeros would be expected to experience higher returns over an 10-year horizon, rather than buying 1-year zeros and reinvesting the proceeds into 1-year zeros at each maturity date.
e. Suppose that we have information that there are liquidity premiums, and that liquidity premiums (measured in basis points) increase with maturity:
Maturity (years) 2 3 4 5 6 7 8 9 10
Liquidity Premium 10 20 35 55 80 110 150 200 250Using this information, what is the expected future path of short-term interest rates in the U.S. on April 11, 2014? Graph the expected future short-term interest rates in your graph from part b.
f. On April 11, 2013, the yield spread between the 10-year Treasury and the 3-month Treasury was 175 basis points. On April 11, 2014, it was 267 basis points. Is it possible that market expectations of future short-term interest rates on April 11, 2014 were unchanged from April 11, 2013? If so, what can account for the steepening of the yield curve?