One-year interest rates are 3%. The market expects one-year rates to be 5% one year from now. The market also expects one-year rates to be 7% two years from now. Assume that the unbiased expectations theory holds. Which of the following is correct?

Question

Quizplus · Accepted Answer

According to the unbiased expectations theory, long-term interest rates are the geometric average of current short-term interest rates and expected short-term rates in the future. In this case, the expected one-year rate one year from now is 5%, which is higher than the current one-year rate of 3%. Therefore, the yield curve is upward sloping.

One-Year Interest Rates Are 3