Over the next three years,the expected path of 1-year interest rates is 4,1,and 1 percent. The expectations theory of the term structure predicts that the current interest rate on 3-year bond is
A)1 percent.
B)2 percent.
C)3 percent.
D)4 percent.

Question

Quizplus · Accepted Answer

The expectations theory of the term structure suggests that the yield on a longer-term bond will equal the geometric average of short-term interest rates expected to prevail over the life of the long-term bond. Here, the average of the expected 1-year interest rates over the next three years (4%, 1%, 1%) is calculated as the geometric mean: [(1.04 * 1.01 * 1.01)^(1/3)] - 1 ≈ 2%. Therefore, the current interest rate on a 3-year bond, according to the expectations theory, would be approximately 2%.

Over the Next Three Years,the Expected Path of 1-Year Interest