Jeff is trying to forecast what the annual interest rate on a three-year bond will be two years from now,and he believes that the expectations hypothesis is the basis upon which he should build his forecast.Currently the rates of return on bonds of different maturities look like this: Maturity Rate
1-year 3.00%
2-year 3.50%
3-year 3.75%
4-year 4.00%
5-year 4.00%
Based on the expectations hypothesis,what forecast should Jeff make for the return on a three-year bond,two years in the future?

Question

Quizplus · Accepted Answer

The expectations hypothesis states that the long-term interest rate is equal to the average of the expected short-term interest rates over the life of the bond. In this case, the three-year bond has two years to maturity, so the expected return on the three-year bond two years from now is the average of the one-year and two-year rates two years from now. The one-year rate two years from now is expected to be 4.00%, and the two-year rate two years from now is expected to be 4.25%. Therefore, the expected return on the three-year bond two years from now is (4.00% + 4.25%) / 2 = 4.125%.

Jeff Is Trying to Forecast What the Annual Interest Rate