Suppose there are only two kinds of securities: one-year bonds and two-year bonds. Suppose both currently yield 5 per cent in the market. Now suppose that the market rate on one-year bonds is expected to be only 4 per cent next year. According to the Expectations Theory and assuming you intend to maximize return, (a) Which bond do you prefer to hold if you have a two-year holding period? Why? (b) Would your preference identified in question (a) above, change if you have a oneyear holding period? (c) Suppose the current one-year rate did rise to 5.5 per cent and that the current twoyear rate fell to 4.75 per cent, which bond do you prefer to hold (assuming that the one-year bond rate is still expected to be 4 per cent next year)

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