PROBLEMS

1. Suppose the following interest rate structure was observed in 2000 and 2001:

                                                                    Yield (%)

                 Bond                                                          2000                2001

                                                                                    3-month treasury bill               12.00               14.00

                                                                                    1-year government bond         12.50               14.50

                                                                                    3-year government bond         12.75               14.75

                                                                                    5-year government bond         13.00               15.00

                                                                                    10-year government bond       13.30               15.30

a) In light of the expectations hypothesis, explain what the yield curves say about future interest rates.

b) If real interest rates were the same in both years, what might have caused the shift in the yield curve?

2. Consider the following forecasts of future interest rates:

                                                                                    Yield               R₁        E₁¹       E₁²       E₁³       E₁⁴

                                                                                    %                     6.6       6.4       5.6       5.2       5

Using the expectations hypothesis, predict the shape of the yield curve.

3. What would be the possible explanation for a flat yield curve given by the following theories?

a) expectations hypothesis

b) market segmentation hypothesis

c) liquidity premium theory

4. If you thought an economic expansion was imminent, would you be better off holding short-term or long-term bonds? Explain.