2. As a manager at a large money center bank (that has a very high credit rating) you are responsible for looking for opportunities to make a profit from the movements of the financial markets. Assume you are looking at the current level of interest rates and see the following rates. Return on a 6-month savings account = 0.6% annually (or 0.3% semiannual) Return on a forward rate contract that locks in the interest rate from time 6 months to time 1 year = 0.9% annually (or 0.45% semiannually) Cost of borrowing for one year = 0.7% annually (interest compound annually)

i) If you borrow 10,000,000 today and are required to pay back the principal plus interest at the end of the year, how much will you owe? (2 points)

ii) If you placed the 10,000,000 in the savings account for six months and entered into a contract that locks in the forward interest rate from time 6 months to 1 year, how much money will you have from the two periods? (2 points)

iii) Combining i) and ii) what would be the profit or loss on your transactions? (2 points)

iv) As a manager at a high rated very safe financial institution, assume you can either borrow or lend at the rates shown in i) and ii). According to the pure expectations theory of the yield curve, the return on i) and the cost you pay in ii) should be the same. Assume you can observe the 6 month rate and 1 year rate, based on the simple example in the notes of the pure expectations theory of the yield curve, what should the forward rate be that is implied by the 6 month and 1 year rate? (4 points)