Financial Institution Coursework

Unit III Financial Institution
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Introduction
Yearly rates are 4%, 5%, 6%, 7%, and 8% for the next five years. Please compute and explain the expected interest rate for both the three and four-year bonds if we show the liquidity premiums to be 1.25%, 1%, .75%, .5%, and 0%.
yearrateExpectedLiquidityExpectedRate (%)Premium (%)rate(with premium)14%41.255.2525%(0.04+0.05)/24.515.536%(0.04+0.05+0.06)/350.755.7547%(0.04+0.05+0.06+0.07)/45.50.5658%0.04+0.05_0.06+0.07+0.08)/5606
The calculations are based on the assumptions of liquidity premium given that the interest rate of long-term bonds as well as the liquidity premium corresponding to the supply and demand of the bond. For the first year only the yearly rates and the liquidity premiums, but for the second to the fifth year, the expected interest rates will depend on the sum of the yearly interest rates divided by the years and then summing up with the liquidity premium. The liquidity premium has decreased over time, this is an anomaly, but the sum of the expected rate before premium and the liquidity premium demonstrated that there was an increase in the rates for the third and fourth years at 5.755 and 6%.
Given that the liquidity of long-term bonds is lower than the short-term bonds, the positive liquidity premium compensates the investor for holding the bonds with low liquidity as such. The liquidity premium is taken into account in light of ‘investor compensation’, and the calculations demonstrate that in the event that long-term bonds have higher yields that short-term bonds then are investors more likely to invest in the long-term bonds.
What is the term structure of interest rates, and its three facts?
The term structure of interest rates relates to the relationship that exists for bond yields and different maturities the depiction of interest rate and the time of maturity is also known as the yield curve. It explains expectations about changes in the interest rates, and market participants may anticipate monetary policies that are likely to influence the term structure of interest rates. Typically, the yield curve is upward sloping, since bonds with longer maturity periods have higher interests associated with risks of holding them. The slope represents the short-term interest which reflects the expectations of the bond market participants about the future. As such, it is potentially useful to forecast economic variables as well as inflation rate. The expectations theory, segmented markets theory and the liquid premium theory have been advanced to explain the behavior of yield curves over time.
According to Mishkin & Eakins (2012), the three facts of term structure of interest rates are:
Interest on bonds of different maturities move together
If short-term interest rates are low,...