If the expected path of one-year interest rates over the next five years is 4 percent,5 percent,7 percent,8 percent,and 6 percent,then the expectations theory predicts that today's interest rate on the five-year bond is
A)4 percent.
B)5 percent.
C)6 percent.
D)7 percent.

Question

Quizplus · Accepted Answer

The expectations theory states that the long-term interest rates are the geometric average of expected future short-term rates. In this case, the average of the expected one-year interest rates is:

(1.04 x 1.05 x 1.07 x 1.08 x 1.06)^(1/5) -1 = 1.077 - 1 = 0.077 or 7.7%.

Therefore, today's interest rate on the five-year bond is expected to be 7 percent, which is closest to (C) 6 percent.

If the Expected Path of One-Year Interest Rates Over the Next