Assume the expectations hypothesis regarding the term structure of interest rates is correct. If the current one-year interest rate is 3% and the one-year-ahead expected one-year interest rate is 5%, then the current two-year interest rate should be:
A) 3%.
B) 5%.
C) 4%.
D) 8%.

Question

Quizplus · Accepted Answer

The expectations theory suggests that long-term interest rates are the average of the expected short-term rates over the same term. So, if the one-year-ahead expected one-year interest rate is 5%, then the expected one-year interest rate in the second year should also be 5%. Therefore, the current two-year interest rate can be calculated as the average of the current one-year interest rate (3%) and the expected one-year interest rate in the second year (5%), which equals 4%. Thus, choice C) 4% is the correct answer.

Assume the Expectations Hypothesis Regarding the Term Structure of Interest