Assume the current interest rate on a one-year Treasury bond (₁R₁) is 5.50 percent, the current rate on a two-year Treasury bond (₁R₂) is 5.95 percent, and the current rate on a three-year Treasury bond (₁R₃) is 8.50 percent. If the unbiased expectations theory of the term structure of interest rates is correct, what is the one-year interest rate expected on Treasury bills during year 3, ₃f₁?

Question

Quizplus · Accepted Answer

The unbiased expectations theory suggests that the long-term interest rates are the average of current and expected future short-term rates. Using this, we can calculate the expected one-year rate in year 3 by solving the equation: (1 + 0.085)^3 = (1 + 0.055)(1 + 0.0595)(1 + x), where x is the expected rate. Solving for x gives approximately 13.79 percent.

Assume the Current Interest Rate on a One-Year Treasury Bond