Suppose the pure expectations theory of the term structure is correct. You can buy a 2-year...

Suppose the pure expectations theory of the term structure is correct. You can buy a 2-year discount bond with a face value of $1500 for $1360.54. You plan to sell it next year for a price you expect will be $1456.31

a. What is the annual rate of return on 2-year bonds? Explain?

b. What is the rate of return on a 1-year discount bond you expect will hold next year? Explain.

c. What is the rate of return on a 1-year discount bond today? Why?

d. Suppose that, contrary to what was found in part c., the current one-year rate was .04 (4%). Explain what forces would move it to the level you found in part c. (Hint: there are arbitrage opportunities?)

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Expert Solution

Rahul Sunny answered 1 year ago

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