Consider the bond market to be in equilibrium according to the complete theory of the term structure of interest rates. The current interest rate on one-year bonds is 2 percent, and you believe, as does everyone in the market, that in one year the interest rate on one-year bonds will be 3 percent, and in two years, the interest rate on one-year bonds will be 4 percent. That is, using the standard notation, i 0 = 2%, i 1 = 3%, and i 2 = 4%.

Assume that there is no term premium on a one-year bond.

a. According to the expectations theory of the term structure of interest rates, what will the interest rate be today on a two-year bond and a three-year bond? That is, what are i 0 and i 0 ? Page - 3 Suppose the term premium equals 0.75 percent the number of years to maturity, for the 2- year bond and the 3-year bond.

b. Calculate the interest rate today on the two-year bond and the three-year bond, incorporating the term premium.