1. Interest rate fundamentals: The real rate of return John Smith, a trainee at an investment banking firm, is trying to get an idea of what real rate of return investors are expecting in todays marketplace. He has looked up the rate paid on 3 month U.S Treasury bills and found it to 5.5% on an annualized basis. He has decide to use the rate of change in the Consumer Price Index as a proxy for the inflationary expectations of investors. That annualized rate now stands at 3%. On the basis of the information that John has collected, what estimate can he make of the real rate of return?

2. Nominal and real rates and yield curves Exxon wanting to evaluate interest rate behavior has gathered data on the nominal rate of interest and on inflationary expectations for five U.S. Treasury securities, each having a different maturity and each measured at a different point in time during the year just ended. (Note: Assume that the risk that future interest rate movements will affect longer maturities more than shorter maturities is zero; that is, there is no maturity risk ) These data are summarized in the following table

Maturity US Treasury Point in time (Years) Nominal nflationary rate of interest security Jan-07 Mar-12 May-30 Aug-15 Dec-30 2 10 0.5 20 5 12.6 11.2 13.0 11.0 11.4 expectation 9.5 8.2 10.0 8.1 8.3 a. Using the preceding data, find the real rate of interest at each point in time (5 pts.) b. Describe the behavior of the real rate of interest over the year. (5 pts) c. Draw the yield curve associated with these data, assuming that the nominal rates were measured at the same point in time. (5 pts.) d. Describe the resulting yield curve in part c, and explain the general expectations embodied in it. (5 pts)