Suppose that investors prefer one-year bonds to three-year bonds and will purchase a three-year bond only if they expect to receive an additional 2% over the return from holding one-year bonds. Currently, one-year bonds yield 3%, but investors expect this yield to rise to 4% next year and to 6% the year after.

a. Which of the three models of term structure is relevant in this case?

b. What is the yield on the 3-year bond?

c. Graph the yield curve. Clearly label your graph.