An investor with a six-year investment horizon believes that interest rates are determined only by expectations about future interest rates, (i.e. ,this investor believes in the expectations theory).This investor should expect to earn the same rate of return over the 6-year time horizon if he or she buys a 6-year bond or a 3-year bond now and another 3-year bond three years from now (ignore transaction costs).

Question

Quizplus · Accepted Answer

According to the expectations theory, the yield curve reflects market expectations about future interest rates. If an investor believes in this theory, they would expect the yield on a 6-year bond to be equal to the average yield of a 3-year bond today and the expected yield on a 3-year bond in three years' time. Therefore, the investor should expect to earn the same rate of return over the 6-year time horizon whether they buy a 6-year bond or a 3-year bond now and another 3-year bond three years from now.

An Investor with a Six-Year Investment Horizon Believes That Interest