Assume that the expectations theory holds and that liquidity and maturity risk premiums are zero. The annual rate of interest on a two-year Treasury bond is 10.5 percent and the rate on a one-year Treasury bond is 12 percent. What is the expected one-year interest rate during the second year?
A)9.0%
B)9.5%
C)10.0%
D)10.5%
E)11.0%

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 two-year rate of 10.5% and a current one-year rate of 12%, we can set up the equation: (12% + x) / 2 = 10.5%, where x is the expected rate for the second year. Solving for x gives us 9%.

Assume That the Expectations Theory Holds and That Liquidity and Maturity