“According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond if interest rates on one-year bonds are expected to be the same in both years.” Is this statement true, false, or uncertain?

If bond investors decide that 30-year bonds are no longer as desirable an investment as they were previously, predict what will happen to the yield curve, assuming (a) the expectations theory of the term structure holds; and (b) the segmented markets theory of the term structure holds.If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market’s predictions for the inflation rate in the future?If a yield curve looks like the one shown in the figure below, what is the market predicting about the movement of future short-term interest rates? What might the yield curve indicate about the market’s predictions for the inflation rate in the future?If yield curves, on average, were flat, what would this say about the liquidity (term) premiums in the term structure? Would you be more or less willing to accept the expectations theory?Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?

The following questions are not taken from the textbook.

Answers to the Questions on Using the term structure to forecast interest rates

Suppose that the interest rates on one- to five-year bonds are currently 7%, 6%, 5%, 6% and 7%, and that the term premiums for one- to five-year bonds are 0%, 0.25%, 0.35%, 0.40%, and 0.50%.

a. Predict what the one-year interest rate that is expected to prevail two years from today (i.e., for next year, iit+1e).

b. Predict what the one-year interest rate that is expected to prevail three years from today (i.e., iit+2e).

(Harder) Your employer (a bank) has decided to offer four-year loans to its small

business customers one year from today. You have been presented the task of determining what

the appropriate minimum interest rate should be for the most credit-worthy customer. The

decision to select a particular fixed rate for the loans depends on our forecast of the interest rates

and our internal efficiency of managing the loan. This requires compensation for the costs of

making the loan plus profit. You are to use the most recent interest rates on Treasury bonds as

the basis for determining the minimum interest rate on the small business fixed-rate loans.

Your boss indicates that the bank needs to charge two percentage points more than the expected

interest rate on a Treasury bond with the same maturity (i.e., 4 years). In addition, the bank has

estimated the term premium to be 0.9%, which will prevail on a four-year bond next year.

In today’s issue of the Wall Street Journal, you found that the interest rates on one- to five-year

bonds are currently 4%, 5%, 6%, 7% and 8%. (Don’t confuse these interest rates with the oneyear

interests over the next five years. In fact, you are to calculate the expected one-year interest

rates to prevail in the near future as a part of this exercise.)

A. According to the expectation hypothesis, what is the one-year interest rate that is expected to

prevail three years from today? That is, calculate the expected rate for one-year Treasury

bond in three years (i.e., i1t+2

e ).

B. Based on the information above and the liquidity premium/preferred habitat theory, calculate

and predict interest rates as follows. Now assume that the current term premiums for one- to

five-year bonds are 0%, 0.25%, 0.35%, 0.40% and 0.50%.

a. Calculate the adjusted forward rate for a one-year Treasury bond two years from today

(i.e., for next year, i1t+1

e

).

b. Calculate the adjusted forward rate for a one-year Treasury bond three years from today

(i.e., iit+2

e).

c. Calculate the adjusted forward rate for a one-year Treasury bond four years from today

(i.e., iit+3

e).

d. Calculate the adjusted forward rate for a one-year Treasury bond five years from today

(i.e., iit+4

e).

C. Given your answer to the question B and the liquidity premium theory, what interest rate is

expected on a four-year Treasury bond one year from today (i.e., e

i4,tï€«1)? Use the estimated

term premium of 0.9%.

D. Finally, what is your recommended minimum interest rate for the four-year fixed rate loans

to be made next year?

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