If the expected path of 1-year interest rates over the next four years is 5 percent,4 percent,2 percent,and 1 percent,then the expectations theory predicts that today's interest rate on the four-year bond is
A)1 percent.
B)2 percent.
C)3 percent.
D)4 percent.

Question

Quizplus · Accepted Answer

The expectations theory suggests that the long-term interest rate for a bond is the geometric average of short-term interest rates expected over the same time period. So, the four-year bond rate will be the average of the four one-year interest rate expectations: [(1+2+4+5)/4] = 3 percent. Therefore, the correct answer is C) 3 percent.

If the Expected Path of 1-Year Interest Rates Over the Next