Question

A)

Given the Term Structure below:

1 year = 3.3%

2 years = 4.9%

3 years = 5.4%

4 years = 6.3%

5 years = 7.5%

Based on the expectations hypothesis, what does the market expect the 1 year rate in 4 year to be?

B)

If the market expects interest rates to fall in the future, what shape would you expect to see in a graph of the Term Structure?

Group of answer choices

Downward sloping

Upward sloping

Humped

Flat

None of these are correct

C)

What is the basic idea behind any calculation based on the Expectation Hypothesis model?

Group of answer choices

Investment strategies that span different amounts of time are expected to earn different amounts over the investment horizon.

Investment strategies that span the same amount of time are expected to earn different amounts over the investment horizon.

Investment strategies that span different amounts of time are expected to earn the same amount over the investment horizon.

Any investment strategy that spans the same amount of time, is expected to earn the same amount over the investment horizon.

None of these are correct.

D)

Which type of investor might have a particular preference for long term bonds, independent of market interest rates?

Group of answer choices

Pension funds

Money market funds.

Corporations raising large amounts of capital.

All of these investors would prefer long term bonds.

None of these investors would prefer long term bonds.

Answer 1

a)Given the Term Structure

5 years = 7.5%

4 years = 6.3%

Assume 5 years = 7.5% as r5

Assume 4 years = 6.3% as r4

Expected rate of 1year in 4 year formula

=(((1+r5)^5)/((1+r4)^4)) - 1

=(((1+7.5)^5)/((1+ 6.3)^4)) - 1

=(((1+0.075)^5)/((1+ 0.063)^4)) - 1

=((1.43562933)/((1.27682994)) - 1

=0.124370039

=12.43%

Term Structure = 12.43%

b) Correct option is b = Downward Sloping

Explanation:

Interest rate for long duration bond will be less than short duration bond.

C) Correct option is D =Any investment strategy that spans the same amount of time, is expected to earn the same amount over the investment horizon.

D) Correct option is A = Pension funds

Explanation:

Pension funds have more prefers for long duration bonds to correspond  duration

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