Question 1 - Fill in the Blank
Answer is 'Expectations Theory'
Question 2 -
Part a: Based on Pure Expectations Theory,
(1 + 2 Yr Rate)2 = (1 + 1 Yr rate) * (1 + 1 Yr Rate 1 Yr from now)
(1 + 2%)2 = (1 + 1.3%) * (1 + 1 Yr Rate 1 Yr from now)
1.0404 = 1.013 * (1 + 1 Yr Rate 1 Yr from now)
(1 + 1 Yr Rate 1 Yr from now) = 1.027048
1 Yr rate 1 Yr from now =0.027048 = 2.7048%
Part b: Based on Pure Expectations Theory,
(1 + 3 Yr Rate)3 = (1 + 1 Yr rate) * (1 + 2 Yr Rate 1 Yr from now)2
(1 + 3.2%)3 = (1 + 1.3%) * (1 + 2 Yr Rate 1 Yr from now)2
1.099105 = 1.013 * (1 + 2 Yr Rate 1 Yr from now)2
1.085 = (1 + 2 Yr Rate 1 Yr from now)2
1 + 2 Yr Rate 1 Yr from now = 1.041633
2 Yr Rate 1 Yr from now = 4.1633%
Part c: Based on Pure Expectations Theory,
(1 + 3 Yr Rate)3 = (1 + 2 Yr Rate)2 * (1 + 1 Yr rate 2 Yr from now)
(1 + 3.2%)3 = (1 + 2%)2 * (1 + 1 Yr rate 2 Yr from now)
1.099105 = 1.0404 * (1 + 1 Yr rate 2 Yr from now)
(1 + 1 Yr rate 2 Yr from now) = 1.056425
1 Yr rate 2 Yr from now = 0.056425 = 5.6425%
You can calculate the yield curve, given inflation and maturity-related risks. Looking at the yield curve,...
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