The current interest rate on a one-year bond is 4 percent and the current rate on a two-year bond is 4.4 percent. If the expectations theory of the term structure is correct, what is the one-year interest rate expected during Year 2? That is, compute the rate that is expected to exist only during Year 2. (Base your answer on an arithmetic average rather than a geometric average.)

Question

Quizplus · Accepted Answer

According to the expectations theory, the yield on a two-year bond is the average of the current one-year rate and the expected one-year rate in the second year. Given a current one-year rate of 4% and a two-year rate of 4.4%, we can set up the equation: (4% + x)/2 = 4.4%, where x is the expected rate in the second year. Solving for x gives us 4.8%.

The Current Interest Rate on a One-Year Bond Is 4