8. Pure expectations theory

Which of the following is consistent with the pure expectations theory of the yield curve? Check all that apply.

An inverted yield curve suggests that the market thinks short-term interest rates in the future will be lower than they are today.

Long-term interest rates are based on expectations of what short-term interest rates will be in the future.

An upward-sloping yield curve implies that the market thinks short-term interest rates are going to be higher in the future than they currently are.

A flat yield curve suggests that the market thinks interest rates in the future will be the same as they are today.

Yvette would like to invest a certain amount of money for two years and considers investing in a one-year bond that pays 6% and a two-year bond that pays 8%. Yvette is considering the following investment strategies:

	Strategy A: Buy a one-year bond that pays 6% and in one year buy another one-year bond.
	Strategy B: Buy a two-year bond that pays 8% this year and 8% next year.

If the one-year bond that Yvette can purchase in one year pays 7%, Yvette will choose . (Note: Assume there is no compounding.)

On the following graph, use blue points (circle symbol) to draw the yield curve for the two bonds that Yvette can purchase today.

Yield curve0123109876543210YieldTerm

Which of the following describes conditions under which Yvette would be indifferent between Strategy A and Strategy B?

The rate on the two-year bond is 10%.

The rate on the two-year bond is 4%.

The rate on the one-year bond purchased in one year is 4%.

The rate on the one-year bond purchased in one year is 10%.