Consider the following data for bonds A and B:
$\begin{array} { c c c c c }
& \text { price } &&{ \text { annual cash flows } } \
& \dagger = 0 & t = 1 & t = 2 & t = 3 \
\text { A } & \$ 990 & \$ 100 & \$ 1,100 & 0 \
\text { B } & \$ 900 & \$ 50 & \$ 50 & \$ 1,050
\end{array}$
a. Assuming a flat yield curve of 10%, the expectations theory of the term structure, and semi-annual compounding, which bond is a superior investment?
b. If you kept everything the same in part a, except for replacing the assumption of the expectations theory with the assumption of a liquidity premium theory, would your answer to part a be affected and, if so, how?

Question

Consider the following data for bonds A and B:
$\begin{array} { c c c c c } 
& \text { price } &&{ \text { annual cash flows } } \
& \dagger = 0 & t = 1 & t = 2 & t = 3 \
\text { A } & \$ 990 & \$ 100 & \$ 1,100 & 0 \
\text { B } & \$ 900 & \$ 50 & \$ 50 & \$ 1,050
\end{array}$
a. Assuming a flat yield curve of 10%, the expectations theory of the term structure, and semi-annual compounding, which bond is a superior investment?
b. If you kept everything the same in part a, except for replacing the assumption of the expectations theory with the assumption of a liquidity premium theory, would your answer to part a be affected and, if so, how?

Quizplus · Accepted Answer

The Answer of Consider the following data for bonds A and B:
$\begin{array} { c c c c c } 
& \text { price } &&{ \text { annual cash flows } } \
& \dagger = 0 & t = 1 & t = 2 & t = 3 \
\text { A } & \$ 990 & \$ 100 & \$ 1,100 & 0 \
\text { B } & \$ 900 & \$ 50 & \$ 50 & \$ 1,050
\end{array}$
a. Assuming a flat yield curve of 10%, the expectations theory of the term structure, and semi-annual compounding, which bond is a superior investment?
b. If you kept everything the same in part a, except for replacing the assumption of the expectations theory with the assumption of a liquidity premium theory, would your answer to part a be affected and, if so, how?

Consider the Following Data for Bonds a and B A Assuming a Flat Yield Curve of 10%, the Expectations