The yield on a one-year Treasury bond is 5 percent, and the yield on a two-year Treasury bond is 6 percent. Assume that the pure expectations theory holds and that the market is in equilibrium. Which of the following statements is correct?

Question

Quizplus · Accepted Answer

According to the pure expectations theory, the difference between the yields on two bonds of different maturities reflects the expected future short-term interest rates. In this case, the difference between the yields of one-year and two-year bonds is 1%, which represents the market's expectation of the one-year interest rate during the second year. Therefore, the correct statement is that the market expects one-year interest rate during the second year to be 7 percent (Choice C). Note that we cannot determine the sign of the maturity risk premium from the given information, and there is no information on default risk or liquidity risk premiums. Additionally, we cannot conclude that interest rates are expected to fall over the next two years by 3 percent; we only know that the difference in yields is 1%.

The Yield on a One-Year Treasury Bond Is 5 Percent