problem 1: Assume that the interest rate on a 1-year T-bond is 5.0% and that on a 2-year T-bill is 6.0%. Supposing the pure expectations theory is right, what is the market's forecast for 1-year rates 1 year from now?

a) 6.65%
b) 6.74%
c) 6.83%
d) 6.92%
e) 7.01%

problem 2: The real risk-free rate is 3%. Inflation is expected to be 4% this coming year, jump to 5% next year and raise to 6% the year after. According to the expectations theory, what must be the interest rate on 3-year, risk-free securities nowadays?

a) 18%
b) 12%
c) 6%
d) 8%
e) 10%

problem 3: One-year Treasury securities yield 5%, 2-year Treasury securities yield 5.5%, and 3-year Treasury securities yield 6%. Suppose that the expectations theory holds. What does the market expect will be the yield on 1-year Treasury securities two years from now?

a) 6.01%
b) 6.51%
c) 7.01%
d) 7.51%
e) 8.01%

problem 4: Given the following data, find out the expected rate of inflation throughout the next year. Disregard cross-product terms, that is, if averaging is needed, use the arithmetic average.

• r* = real risk-free rate = 3%.
• Maturity risk premium on 10-year T-bonds = 2%. This is zero on 1-year bonds, and a linear relationship exists.
• Default risk premium on 10-year, A-rated bonds = 1.5%.
• Liquidity premium = 0%.
• Going interest rate on 1-year T-bonds = 8.5%.

a) 3.5%
b) 4.5%
c) 5.5%
d) 6.5%
e) 7.5%

problem 5: The real risk-free rate is predicted to remain constant at 3%. Inflation is expected to be 2% a year for the next 3-years, and then 4% a year afterward. The maturity risk premium is 0.1 % (t − 1), where t equals the maturity of the bond. A 5-year corporate bond has a yield of 8.4%. Determine the yield on a 7-year corporate bond that has similar default risk and liquidity premiums as the 5-year corporate bond? Disregard cross-product terms, that is, if averaging is required, use the arithmetic average.

a) 8.73%
b) 8.94%
c) 8.65%
d) 7.98%
e) 9.24%