If the interest rate on a one-year bond today is 7.5 percent and the expected interest rate on a one-year bond one year from now is 5.6 percent, then the interest rate on a twoyear bond will be
A)7 percent
B)12.5 percent
C)8.5 percent
D)6.55 percent

Question

If the interest rate on a one-year bond today is 7.5 percent and the expected interest rate on a one-year bond one year from now is ​5.6 percent, then the interest rate on a two­year bond will be
A)​7 percent
B)​12.5 percent
C)​8.5 percent
D)​6.55 percent

Quizplus · Accepted Answer

To solve this problem, we can use the concept of the expectations theory of interest rates, which suggests that long-term interest rates reflect expectations of future short-term interest rates.

So, if the expected interest rate on a one-year bond in one year is 5.6 percent, then the expected interest rate on a two-year bond starting today can be calculated as the average of the current one-year rate and the expected rate for one year from now:

(7.5% + 5.6%) / 2 = 6.55%

Therefore, the interest rate on a two-year bond is expected to be 6.55 percent. The correct answer is D).

If the Interest Rate on a One-Year Bond Today Is