If the expected path of one-year interest rates over the next five years is 1 percent,2 percent,3 percent,4 percent,and 5 percent,then the pure expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of
A) one year.
B) two years.
C) three years.
D) four years.
E) five years.

Question

Quizplus · Accepted Answer

According to the pure expectations theory, the long-term interest rates are the average of expected future short-term rates. Therefore, the bond with the highest interest rate today is the one with a maturity that matches the highest expected short-term rate, which is 5% in this case. So, the bond with a maturity of five years has the highest interest rate today.

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