A one-year bond has an interest rate of 5% today.Investors expect that in one year,a one year bond will have an interest rate equal to 7%.According to the expectations theory of the term structure of interest rates,in equilibrium,a two-year bond today will have an interest rate equal to

Question

Quizplus · Accepted Answer

The expectations theory of the term structure of interest rates states that long-term interest rates are equal to the geometric average of current and expected short-term interest rates. Therefore, the expected interest rate on a two-year bond today would be the average of the current 1-year interest rate of 5% and the expected 1-year interest rate of 7%, which is (5%+7%)/2 = 6%. Hence, option D) 6% is the correct answer.

A One-Year Bond Has an Interest Rate of 5% Today