Applying the expectations theory, a bank depositor chooses between purchasing a one- year CD paying 5 percent and a two-year CD paying 5.5 percent. If indifferent between the two, the depositor must expect one-year CDs one year from now to have a rate of
A) 6.5%
B) 4.5%
C) 6.0%
D) 5.0%

Question

Quizplus · Accepted Answer

The expectations theory states that the current long-term interest rate is equal to the expected average of future short-term interest rates. In this case, the one-year CD rate is 5% and the two-year CD rate is 5.5%. If the depositor is indifferent between the two, then they must expect the one-year CD rate one year from now to be 6%.

Applying the Expectations Theory, a Bank Depositor Chooses Between Purchasing