Your firm manages money for a professional tennis player Maria Juarez. She has asked you to give her information about what determines the level of various interest rate. Your boss has prepared some questions for you to consider. Please answer the following questions:
1. What is the pure expectations theory? What does the pure expectation theory imply about the term structure of interest rate?
2. Suppose you observe the following term structure for treasury securities (see grid) below, now assume that the pure expectations theory of the term structure is correct. (This implies that you can use the yield curve provided to “back out” the market’s expectations about future interest rates.) What does the market expect will be the interest rate on 1-year securities 1 year from now? What does the market expect will be the interest rate on 3-year securities 2 years from now? Calculate these yields using geometric averages. Maturity Yield 1 year 6.0% 2 years 6.2% 3 years 6.4% 4 years 6.5% 5 years 6.5%
3. Describe how macroeconomic factors affect the level of interest rates. How do these factors explain why interest rates have been lower in recent years?