Assume the Expectations Hypothesis regarding the term structure of interest rates is correct. If the current one-year interest rate is 3% and the expected one-year interest rate is 5%, then the current two-year interest rate should be:
A) 3%
B) 5%
C) 4%
D) 8%

Question

Quizplus · Accepted Answer

According to the Expectations Hypothesis, the current two-year interest rate should be the average of the expected one-year interest rate over the next two years, which is 5%, and the current one-year interest rate, which is 3%. Therefore, the current two-year interest rate should be (5% + 3%) / 2 = 4%. Therefore, the best choice is C) 4%.

Assume the Expectations Hypothesis Regarding the Term Structure of Interest