Question

Suppose that the yield curve shows that the one year bond yield is 3%, the two year yield is 4%, and the three year yield is 5%. Assume that the risk premium on the one year bond is zero, the risk premium on the two year bond is 1%, and the risk premium on the three year bond is 2%. If the risk premiums were all zero, as in the expectation hypothesis, what would the slope of the yield curve be?

Answer 1

With all risk premiums set to zero, the slope of the yield curve would reflect the 1% increase from the one-year yield to the two-year yield and another 1% increase from the two-year yield to the three-year yield.

Step-by-step explanation:

If risk premiums were all zero, as the expectation hypothesis suggests, then the yield curve would only reflect expectations about future short-term interest rates. Without the risk premiums, the one-year, two-year, and three-year yields would be 3%, 4%, and 5% respectively. To find the slope of the yield curve, we can subtract the yield of a shorter-term bond from that of a longer-term bond.

Thus, the slope from one year to two years would be 4% - 3% = 1%, and from two years to three years, it would be 5% - 4% = 1%. Since the expectation hypothesis posits a flat or 'normal' yield curve based purely on expectations of future rates, the slope would be represented by these differences in yields without any adjustments for risk premiums.