3. Pure expectations theory: Two-year bonds Which of the following is consistent with the pure expectations...

3. Pure expectations theory: Two-year bonds

Which of the following is consistent with the pure expectations theory of the yield curve? Check all that apply.

A flat yield curve suggests that the market thinks interest rates in the future will be the same as they are today.

A downward-sloping yield curve suggests that the market thinks interest rates in the future will be lower than they are today.

A flat yield curve suggests that the market thinks interest rates in the future will be higher than they are today.

A downward-sloping yield curve suggests that the market thinks interest rates in the future will be higher than they are today.

Brian would like to invest a certain amount of money for two years and considers investing in a one-year bond that pays 3 percent and a two-year bond that pays 7 percent. Brian is considering the following investment strategies:

	Strategy A: Buy a one-year bond that pays 3 percent and in year one, buy another one-year bond that pays the forward rate in year two.
	Strategy B: Buy a two-year bond, in year one, that pays 7 percent in the first year and 7 percent in the second year.

If the one-year bond purchased in year two pays 7 percent, Brian will choose (STRATEGY A OR B)

Which of the following describes conditions under which Brian would be indifferent between Strategy A and Strategy B?

The rate on the one-year bond purchased in year two pays 11.155 percent.

The rate on the one-year bond purchased in year two pays 11.601 percent.

The rate on the one-year bond purchased in year two pays 12.047 percent.

The rate on the one-year bond purchased in year two pays 9.482 percent.

Solutions

Expert Solution

Which of the following is consistent with the pure expectations theory of the yield curve? Check all that apply.

Option B is correct A downward-sloping yield curve suggests that the market thinks interest rates in the future will be lower than they are today.

Option C is correct. A flat yield curve suggests that the market thinks interest rates in the future will be higher than they are today.

Future value of strategy A = Investment * (1 + Interest)^Years = 1000 * 1.03^2 = $1061

Future value of strategy B = Investment + 2 * Investment * Interest rate + Coupon in year 1 * Interest rate = 1000 + 1000*2*7% + 1000*7%*7%= $1144.9

Strategy B is recommended as its future value is higher

Which of the following describes conditions under which Brian would be indifferent between Strategy A and Strategy B?

(1 + 1 year bond Interest)*(1 + second year interest) = Future value of 2 year bond / investment

(1 + 0.03)*(1 + second year interest) = 1144.90 / 1000

1.03 * (1 + second year interest) = 1.1449

(1 + second year interest) = 1.11155

second year interest = 11.155%

The rate on the one-year bond purchased in year two pays 11.155 percent.

jeff jeffy answered 1 year ago

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