A one-year bond currently pays 5% interest. It's expected that it will pay 4.5% next year and 4% the following year. The two-year term premium is 0.2% while the three-year term premium is 0.35%. What is the interest rate on a two-year bond according to the preferred habitat theory?
A)4.5%
B)4.75%
C)4.95%
D)4.975%

Question

Quizplus · Accepted Answer

The interest rate on a two-year bond, according to the preferred habitat theory, can be calculated by taking the average of the expected interest rates for the next two years and adding the term premium for the two-year bond. The expected interest rates are 5% for the current year and 4.5% for the next year, giving an average of (5% + 4.5%) / 2 = 4.75%. Adding the two-year term premium of 0.2% results in a two-year bond interest rate of 4.75% + 0.2% = 4.95%.

A One-Year Bond Currently Pays 5% Interest