Assume that the current interest rate on a 1-year bond is 8 percent,the current rate on a 2-year bond is 10 percent,and the current rate on a 3-year bond is 12 percent.If the expectations theory of the term structure is correct,what is the 1-year interest rate expected during Year 3? (Base your answer on an arithmetic rather than geometric average. )
A) 12.0%
B) 16.0%
C) 13.5%
D) 10.5%
E) 14.0%

Question

Quizplus · Accepted Answer

The expectations theory suggests that the average of the expected future short-term interest rates will equal the long-term interest rates. The 3-year bond rate (12%) should equal the average of the current 1-year rate (8%), the expected 1-year rate in Year 2, and the expected 1-year rate in Year 3. Solving for the expected rate in Year 3 gives 16%.

Assume That the Current Interest Rate on a 1-Year Bond