Two-year securities are yielding 6 percent, and comparable one-year securities are yielding 8 percent. According to the pure expectations theory, the market expects next year's comparable one-year securities to yield
A) 14 percent.
B) 8 percent.
C) 6 percent.
D) 4 percent.

Question

Quizplus · Accepted Answer

The pure expectations theory suggests that the yield curve reflects market expectations for future interest rates. If two-year securities yield 6% and one-year securities yield 8%, it implies that the market expects the yield on one-year securities to decrease in the future to average out to 6% over two years. The calculation to find the expected yield for next year's one-year securities would support an expectation of a lower rate, specifically 4%, to balance the first year's higher rate of 8%.

Two-Year Securities Are Yielding 6 Percent, and Comparable One-Year Securities