The real risk-free rate of interest is 3 percent.Inflation is expected to be 4 percent this coming year,jump to 5 percent next year,and run at 6 percent the year after (Year 3).According to the expectations theory,what should be the interest rate on 3-year,risk-free securities today?

Question

Quizplus · Accepted Answer

The expectations theory suggests that the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. To calculate the expected interest rate for a 3-year security, we add the real risk-free rate to the expected inflation rates for each year, then average them. The calculation is as follows: Year 1: 3% (real risk-free rate) + 4% (inflation) = 7% Year 2: 3% + 5% = 8% Year 3: 3% + 6% = 9% The average of these rates is (7% + 8% + 9%) / 3 = 8%.

The Real Risk-Free Rate of Interest Is 3 Percent