P5-32 (similar to)

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Suppose the current one-year interest rate is

5.9 %5.9%.

One year from now, you believe the economy will start to slow and the one-year interest rate will fall to

4.9 %4.9%.

In twoyears, you expect the economy to be in the midst of a recession, causing the Federal Reserve to cut interest rates drastically and the one-year interest rate to fall to

1.9 %1.9%.

The one-year interest rate will then rise to

2.9 %2.9%

the following year, and continue to rise by

1 %1%

per year until it returns to

5.9 %5.9%,

where it will remain from then on.

a. If you were certain regarding these future interest rate changes, what two-year interest rate would be consistent with these expectations?

b. What current term structure of interest rates, for terms of 1 to 10 years, would be consistent with these expectations?

c. How does the one-year interest rate compare to the ten-year interest rate?