Question 3.2

Which of the following is consistent with the pure expectations theory of the yield curve? Select all that apply (could be more than one)

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

B. An upward-sloping yield curve suggests that the market thinks interest rates are going to be higher in the future than they are today.

C. A downward-sloping yield curve suggests that the market thinks interest rates in the future will be lower than they are today.

D. A downward-sloping yield curve suggests that the market thinks interest rates in the future will be higher than they are today.

Eileen would like to invest a certain amount of money for two years and considers investing in a one-year bond that pays 4 percent and a two-year bond that pays 8 percent. Eileen is considering the following investment strategies:

Strategy A: In the first year, buy a one-year bond that pays 4 percent. Once that bond matures, buy another one-year bond that pays the forward rate.

Strategy B: In the first year, buy a two-year bond that pays 8 percent annually. If the one-year bond purchased in year two pays 9 percent.

Will Eileen choose Strategy A or Strategy B?

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

A. The rate on the one-year bond purchased in year two pays 10.331 percent.

B. The rate on the one-year bond purchased in year two pays 11.425 percent.

C. The rate on the one-year bond purchased in year two pays 12.154 percent.

D.The rate on the one-year bond purchased in year two pays 13.126 percent.