Sandra Kapple is a fixed-income portfolio manager who works with large institutional clients.

Kapple is meeting with Maria VanHusen, consultant to the Star Hospital Pension Plan, to discuss management of the fund’s approximately $100 million Treasury bond portfolio. The current U.S.

Treasury yield curve is given in the following table. VanHusen states, “Given the large differential between 2- and 10-year yields, the portfolio would be expected to experience a higher return over a 10-year horizon by buying 10-year Treasuries, rather than buying 2-year Treasuries and reinvesting the proceeds into 2-year T-bonds at each maturity date.”

Maturity Yield Maturity Yield 1 year 2.00% 6 years 4.15%

2 2.90 7 4.30 3 3.50 8 4.45 4 3.80 9 4.60 5 4.00 10 4.70

a. Indicate whether VanHusen’s conclusion is correct, based on the pure expectations hypothesis.

b. VanHusen discusses with Kapple alternative theories of the term structure of interest rates and gives her the following information about the U.S. Treasury market:
Maturity (years) 2 3 4 5 6 7 8 9 10 Liquidity premium (%) 0.55 0.55 0.65 0.75 0.90 1.10 1.20 1.50 1.60 Use this additional information and the liquidity preference theory to determine what the slope of the yield curve implies about the direction of future expected short-term interest rates.