Assume the Expectations Hypothesis regarding the term structure of interest rates is correct. Then, if the current two-year interest rate is 5% and the current one-year rate is 6%, then investors expect:
A) The future one-year rate to be 4%
B) The future one-year rate to be 5%
C) The future one-year rate to be 6%
D) The future one-year rate to be 1%

Question

Quizplus · Accepted Answer

According to the Expectations Hypothesis, the two-year interest rate can be expressed as the average of two one-year interest rates. Therefore, if the current two-year rate is 5% and the current one-year rate is 6%, then the implied one-year rate one year from now (i.e., the future one-year rate) must be lower than the current one-year rate in order to bring the average down to 5%. Specifically, it must be 4%, which is choice A.

Assume the Expectations Hypothesis Regarding the Term Structure of Interest