2. It is now date zero. Currently the yield on a one-year bond is 10%, on a two-year bond is 15%, and on a three-year bond is 17%. Furthermore, everyone expects inflation to run at 5% this year, 10% next year and at 15% the year after that. Assuming that the pure expectations model correctly describes the behavior of the term structure, calculate the markets expectation of the following:

a. The nominal interest rate on a one-year bond originating date 1 and maturing date 2. (The one-year rate next year.)

b. The real interest rate on a one-year bond originating date 1 and maturing date 2. (The one-year real rate next year.)

c. The real interest rate on a one-year bond originating date 2 and maturing date 3. (The one-year real rate two years from now.)

3. Suppose the situation is as described in question 2. However, you are firmly convinced that next years one-year nominal interest rate will be 12% rather than the answer you found to 2.a. a. Describe the steps you would take today to put yourself in a position to profit if your belief is correct.

b. If next year it turns out you are right and the one-year interest rate is indeed 12%, describe the steps you would take at that time and demonstrate that a profit results.