[table]
Maturity (yrs) | 1 | 2 | 3 | 4 | 5 Spot Rate zi | 1.00% | 3.00% | 4.00% | 5.00% | 5.50% Liquidity Premium | 0.00% | 0.10% | 0.25% | 0.40% | 0.50%
[/table]The above Treasury Yield Curve data were the general market expectations for the near-term. Which of the following statement during these 5 years is most correct?

Question

BlackTom AI · Accepted Answer

The liquidity premium rises with maturity, so removing it reduces long-term yields more than short-term yields and flattens the curve rather than steepening it.

Relevant concepts: spot (zero) rates include both pure expectations of future short rates and liquidity/term premiums. Subtracting the liquidity premium isolates the pure expectations component. Implied forward (one‑period) rates can be derived from spot rates to infer expected future short rates.

Step-by-step reasoning and calculations:
1) Remove the liquidity premium from each spot rate:
- 1‑yr adjusted = 1.00% − 0.00% = 1.00%
- 2‑yr adjusted = 3.00% − 0.10% = 2.90%
- 3‑yr adjusted = 4.00% − 0.25% = 3.75%
- 4‑yr adjusted = 5.00% − 0.40% = 4.60%
- 5‑yr adjusted = 5.50% − 0.50% = 5.00%
Original slope (1yr → 5yr) = 5.50% − 1.00% = 4.50%
Adjusted slope = 5.00% − 1.00% = 4.00%
Since the slope decreases when LPs are removed, the curve becomes less steep — so the statement “In the absence of Liquidity Premiums, the Yield Curve would have been steeper” is incorrect.

2) Compute an implied forward (expected) 1‑yr rate for year 2 to show expectations are not falling:
f(1→2) = (1+z2)^2 / (1+z1) − 1 = (1.03^2 / 1.01) − 1
1.03^2 = 1.0609; 1.0609 / 1.01 = 1.050396; minus 1 = 0.050396 ≈ 5.04%
This shows the market expects a much higher short rate in year 2 than today, inconsistent with “inflation expectations are falling.” Hyper‑inflation is clearly not implied by 1–5.5% spot rates. And we can derive implied short/forward rates (so “We cannot derive the Short Rates” is false).

Why the correct answer is correct: each of the four listed substantive statements is contradicted by the data and the simple adjustments above. Therefore the only correct choice is “All of the other choices are actually incorrect statements.”

Final confirmation: the correct answer is “All of the other choices are actually incorrect statements.”

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