You observe the following term structure:

Effective annual YTM

1- year zero-coupon bond

2- year zero-coupon bond

3- year zero-coupon bond

4- year zero-coupon bond

3.1%

3.2%

3.3%

3.4%

(a) If you believe that the term structure next year will be the same as today, determine whether the 1-year or the 4-year zeros provide a greater expected 1-year return.

(6 marks)

(b) What is the expectations hypothesis? Explain how your belief, mentioned in part (a) that the term structure next year will be the same as today would differ if you now believe solely in the expectations hypothesis. (8 marks)