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6 May 2019

Assume that interest rates for one-year securities are expected to be 2 percent today, 4 percent one year from now, and 6 percent two years from now. Using only pure expectations theory, what are the current interest rates on two- year and three-year securities?

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Reid Wolff
Reid WolffLv2
8 May 2019

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One-year Treasury securities yield 5%. The market anticipates that 1 year from now, 1-year Treasury securities will yield 6%. If the pure expectations theory is correct, what is the yield today for 2-year Treasury securities? Calculate the yield using a geometric average.

Directions: Answer the following questions. Explain how youreached the answer or show your work if a mathematical calculationis needed, or both.

1. Assume that as of today, the annualized interest rate on athree-year security is 8 percent, while the annualized interestrate on a two-year security is 6 percent. Use only this informationto estimate the one year forward rate two years from now.

2. You need to choose between investing in a a one-yearmunicipal bond with a 6 percent yield and a one year corporate bondwith a 9 percent yield. If your marginal federal income tax rate is20 percent and no other differences exist between these twosecurities, which one would you invest in?

3. Assume that interest rates for one-year securities areexpected to be 3 percent today, 6 percent one year from now, and 7percent two years from now. Using only the pure expectationstheory, what are the current interest rates on two-year andthree-year securities?

4. Identify some factors that influence the shape of the yieldcurve. Describe how financial market participants use the yieldcurve to make decisions.

5. Assume there is a sudden expectation of increasing interestrates in the future. What would be the effect on the shape of theinterest curve? Explain.

6. Identify the primary objectives of the Federal Open MarketCommittee and the means by which it attempts to achieve theseobjectives.

7. What is the Beige Book and why do market participants payattention to it?

8. Is it the role of the Fed or Congress to determine the fateof large financial institutions that are near bankruptcy?

9. Does the Federal Reserve directly or indirectly influenceequity security prices? Based on your response, do equity marketparticipants focus on current Fed actions or the expected ones whenit comes to pricing equity securities?

10. Visit the Consumer Financial Protection Bureau's website.Identify one policy objective and its effects on consumers andbusinesses.

Directions: Answer the following questions on a separatedocument. Explain how you reached the answer or show your work if amathematical calculation is needed, or both. Submit your assignmentusing the assignment link above. This homework assignment is worth20 points. Assume that as of today, the annualized interest rate ona three-year security is 8 percent, while the annualized interestrate on a two-year security is 6 percent. Use only this informationto estimate the one year forward rate two years from now. You needto choose between investing in a a one-year municipal bond with a 6percent yield and a one year corporate bond with a 9 percent yield.If your marginal federal income tax rate is 20 percent and no otherdifferences exist between these two securities, which one would youinvest in? Assume that interest rates for one-year securities areexpected to be 3 percent today, 6 percent one year from now, and 7percent two years from now. Using only the pure expectationstheory, what are the current interest rates on two-year andthree-year securities? Identify some factors that influence theshape of the yield curve. Describe how financial marketparticipants use the yield curve to make decisions. Assume there isa sudden expectation of increasing interest rates in the future.What would be the effect on the shape of the interest curve?Explain. Identify the primary objectives of the Federal Open MarketCommittee and the means by which it attempts to achieve theseobjectives. What is the Beige Book and why do market participantspay attention to it? Is it the role of the Fed or Congress todetermine the fate of large financial institutions that are nearbankruptcy? Does the Federal Reserve directly or indirectlyinfluence equity security prices? Based on your response, do equitymarket participants focus on current Fed actions or the expectedones when it comes to pricing equity securities? Visit the ConsumerFinancial Protection Bureau's website. Identify one policyobjective and its effects on consumers and businesses.

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