According to expectations theory if the 2 year interest rate is 4% and the 1 year rate is now 3%, the 1 year rate next year is expected to be
A) 8%.
B) 5%.
C) 4%.
D) 3%.

Question

Quizplus · Accepted Answer

Expectations theory suggests that the future interest rate for a period can be derived from the current long-term rate and the current short-term rate. Here, if the 2-year rate is 4% and the current 1-year rate is 3%, the expected 1-year rate next year would need to average out to 4% over the two years. This means the expected rate for the next year would be higher than 4% to average out the first year's 3%. The calculation is: [(1+0.04)^2 / (1+0.03)] - 1 = 5%.

According to Expectations Theory If the 2 Year Interest Rate