1. Several theories have been advanced to explain the shape of the yield curve. The three major ones are the market segmentation theory, the liquidity preference theory, and the expectations theory. Briefly describe each of these theories. Do economists regard one as being “true”?
2. Suppose most investors expect the rate of inflation to be 2% next year, 4% the following year, and 3% thereafter. The real risk-free rate is 3%. The maturity risk premium is zero for bonds that mature in one year or less, 0.1% for 2-year bonds; the MRP increases by 0.1% per year thereafter for 20 years, then becomes stable. What is the interest rate on 1-, 10-, and 20-year Treasury bonds? Draw a yield curve with these data. Is your yield curve consistent with the three term structure theories?