A two-year interest rate is 7% and a one-year forward rate one year from now is 8%. According to the expectations theory, what is the current one-year rate?
A) 6.0%
B) 6.5%
C) 7.0%
D) 8.0%
E) 9.0%

Question

Quizplus · Accepted Answer

According to the expectations theory, the two-year interest rate is the average of the current one-year rate and the one-year forward rate one year from now. Thus, (current one-year rate + 8%)/2 = 7%. Solving for the current one-year rate gives 6%.

A Two-Year Interest Rate Is 7% and a One-Year Forward