Using the pure expectations approach to the determination of interest rates,calculate the expected (E) rate of interest of a one-year investment that will be available in 12 months' time (₁i₁) ,given the following data:
Current rate of return on a one-year-to-maturity (₀i₁) instrument:7.75% per annum
Current rate of return on a two-year maturity (₀i₂) instrument:8.25% per annum

Question

Quizplus · Accepted Answer

The pure expectations approach assumes that investors form their expectations of future interest rates based on current market conditions and expectations of future economic factors. In this case, since we are determining the expected rate of interest for a one-year investment that will be available in 12 months' time, we should look at the current rate of return on a two-year maturity instrument (8.25% per annum) and subtract the current rate of return on a one-year-to-maturity instrument (7.75% per annum). This gives us an expected increase in interest rates of 0.5% per annum over the next year. Therefore, the expected rate of interest for a one-year investment that will be available in 12 months' time would be 7.75% + 0.5% = 8.25% per annum. So the best choice is C) 8.75% per annum which is not given as a choice but the calculation yields 8.25% so the closest option is C.

Using the Pure Expectations Approach to the Determination of Interest