1. (a) Suppose the expectations theory of the term structure is correct. Suppose that the current interest rate on a one-year Treasury bill is 3 percent. Suppose the one-year T-bill rate is expected to rise to 4 percent one year from today, then to 5 percent the following year, and then stay at 5 percent thereafter. Compute the interest rate on current Treasury securities with maturities of one year, two years, three years, four years and five years, and plot the yield curve.

The term structure of interest rates for bonds with different maturities is given by:

Interest rate on a 1?yr.bond

Interest rate on a 2?yr.bond

Interest rate on a 3?yr.bond

Interest rate on a 4?yr.bond

Interest rate on a 5?yr.bond

(b) Repeat the exercise in part (a), but assume instead that the one-year T-bill rate is 8 percent currently, and that the one year T-bill rate is expected to fall to 6 percent one year from today; fall to 4 percent the following year; rise back to 6 percent the year after that; and then stay at 6 percent thereafter.

2. Use a picture to show the impact on the yield curve of the following shocks, assuming that the expectations theory is correct and that the initial yield curve is flat. Start by drawing a bond market supply and demand diagram to figure out what will happen to short-term interest rates when the shocks occur. Compare today’s short-term interest rates to expected short interest rates in the future, and then apply the expectations theory’s predictions to determine whether the yield curve should slope up or down.

3. The 1-year bond matures in April 2015 and the 2-year and 3-year in April 2016 and 2017. Assume the pure Expectation theory is correct. Calculate the expected interest rates on a 1-year bonds one year from now (????????)and 2-years from now (????????). [Show your work]

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