If the expected path of interest rates on one-year bonds over the next five years is 2%, 4%, 3%, 2%, and 1%, the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of
A)one year.
B)two years.
C)three years.
D)five years.

Question

Quizplus · Accepted Answer

According to the expectations theory, the interest rate on a long-term bond is the average of the expected future short-term interest rates. Since the expected path starts at 2% and increases, the one-year bond, which reflects the current short-term rate, will have the lowest interest rate today.

If the Expected Path of Interest Rates on One-Year Bonds