The following pattern for oneyear Treasury bills is expected

The following pattern for one-year Treasury bills is expected over the next four years:

Year 1:            5%

Year 2:            6%

Year 3:            8%

Year 4:            11%

a.         What return would be necessary to induce an investor to buy a

two-year security

three-year security

four year security

b.         Graph the term structure of interest rates for years 1 through 4.

Solution

a. Two year security = (1.05*1.06)^1/2 - 1 = 5.50%

b. three year security = (1.05*1.06*1.08)^1/3 - 1 = 6.33%

c. four year security = (1.05*1.06*1.08*1.11)^1/4 - 1 = 7.48%

plot the following with N on the X axis