Assume the Expectation Hypothesis regarding the term structure of interest rates is correct. Then, if the current one-year interest rate is 4% and the two-year interest rate is 6%, then investors are expecting the future one-year rate to be:
A) 4%.
B) 8%.
C) 6%.
D) 5%.

Question

Quizplus · Accepted Answer

According to the Expectation Hypothesis, the future interest rate can be calculated based on the average of the current and expected future rates. Given a current one-year rate of 4% and a two-year rate of 6%, the expected future one-year rate can be calculated as follows: (2*6%) - 4% = 12% - 4% = 8%. This means investors are expecting the one-year rate, one year from now, to be 8%.

Assume the Expectation Hypothesis Regarding the Term Structure of Interest