Question

Compute the two-year nominal interest rate using the exact formula and the approximation formula for each set of assumptions listed in (a) through (c).
a. it = 2%; it+1=3%
b. it = 2%; it+1+1 = 10%
c. it=2%; 1t+1=3%. The term premium on a two-year bond is 1%.

Answer 1

Answer:

a) 2.5%

b) 6%

c) 3.5%

Explanation:

The Formula to be used is the habitat hypothesis

as stated in the document attached below

a)  it = 2%; it+1 =3%

$i_{2,t}$ = 0 + ( 2 + 3 ) / 2

    = 2.5% ( two year nominal interest rate )

b) it = 2%;  it+1+1 = 10%

$i_{2,t}$ = 0 + ( 2 + 10 ) / 2

     = 6% ( two year nominal interest rate )

c) it = 2%;  1t+1 = 3%. ∝₂,t = 1%

$i_{2,t}$  = 1 + ( 2 + 3 ) / 2

     = 1 + 2.5 = 3.5%