Question

1. The table below is the YTM of U.S. Treasuries with different maturities on April 1, 2020.

1 yr.	2 yr.	3 yr.	5 yr.	7 yr.
0.16%	0.23%	0.28%	0.37%	0.51%

1. What is the expected two-year rate in three years according to the Pure Expectations Theory?                                                      

b.What is an inverted yield curve? Give one reason that may cause the yield curve to invert.                   

Answer 1

Solution

1.

Expected two year rate in three years is given by the formula as
=((1+r5)^5/(1+r3)^3)^(1/2)-1
=((1+0.37%)^5/(1+0.28%)^3)^(1/2)-1
=0.51%

2.
Inverted yield curve is when long term maturity bonds have lower yield than short term maturity bonds, i.e., long-term yields fall below short-term yields

Most investors believe short-term rates are going to decline sharply at some point in future. One reason that the yield may be inverted because investors expect recession