Assume an investor has a choice of 3 consecutive one-year bonds or one 3-year bond. Assuming the expectations hypothesis of the term structure of interest rates is correct the:
A) average interest rate of the three consecutive one-year bonds should be less than the 3- year bond to reflect the risk premium.
B) interest rate of the 3-year bond should equal the average interest rate of the 3 one-year bonds.
C) three consecutive one-year bonds must have the same interest rate.
D) current one-year interest rate must equal the current 3-year interest rate.

Question

Quizplus · Accepted Answer

According to the expectations hypothesis of the term structure of interest rates, the interest rates on a series of short-term bonds should be equal to the average interest rate on a longer-term bond. Therefore, the interest rate on the 3-year bond should equal the average interest rate of the 3 one-year bonds. Choosing the 3-year bond would be the best option as it would provide the same return as investing in the three consecutive one-year bonds, but with less reinvestment risk.

Assume an Investor Has a Choice of 3 Consecutive One-Year