One-year Treasury bills currently earn 3.15 percent. You expected that one year from now, 1-year Treasury bill rates will increase to 3.65 percent and that two years from now, one-year Treasury bill rates will increase to 4.05 percent. If the unbiased expectations theory is correct, what should the current rate be on three-year Treasury securities?

Question

Quizplus · Accepted Answer

The current rate on three-year Treasury securities should be 3.62 percent. This is because the unbiased expectations theory states that the current rate on a long-term security is equal to the average of the expected future short-term rates. In this case, the expected future short-term rates are 3.65 percent and 4.05 percent, so the average is 3.85 percent. However, the current rate on one-year Treasury bills is 3.15 percent, so the current rate on three-year Treasury securities should be higher than 3.85 percent to compensate for the risk of investing in a longer-term security.

One-Year Treasury Bills Currently Earn 3