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Valuation of Bond at applicable inflation rates and change in the risk free rates.

A one-year-maturity U.S. Treasury bond currently yields 1.50%.  Investors forecast that the one-year Treasury bond rate will rise to 2.10% one year from now and to 2.50% two years from now.

Required:

a. If U.S. Treasury Bonds are risk free and investors anticipate inflation of 0.60% in the coming year, how would the Fisher model explain the current one-year rate (in both words and numbers)?

b. Assuming the expectations hypothesis is exactly true (unbiased), what rate should you see for a three-year-maturity Treasury Bond in today's Wall Street Journal?

c. A one-year maturity California municipal bond currently yields 1.15%.  If your income level places you in the 25% federal tax bracket and the 6% state tax bracket (you live here in New York), would you prefer to invest in the one-year maturity U.S. Treasury Bond or the California municipal bond?  (Show your analysis)

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