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, the interest rate of a long-term bond should be equal to the average of the expected short-term interest rates over the life of the long-term bond. In this case, the 3-year bond would have an interest rate equal to the average of the expected one-year interest rates over the next three years, which is the same as the average interest rate of the three consecutive one-year bonds. Therefore, the best choice would be to go with the 3-year bond as it would offer the same overall return as the three consecutive one-year bonds, but with less risk as there is no need to reinvest the proceeds each year.

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