Assume the current one-year interest rate on a bond is 4%, and the one-year expected rate a year from now is 8%. According to the expectations theory of the term structure of interest rates, the two-year interest rate is

Question

Quizplus · Accepted Answer

According to the expectations theory of the term structure of interest rates, the long-term interest rates are equal to the geometric average of current and expected short-term interest rates. So, the two-year interest rate can be calculated as the geometric average of the current one-year interest rate (4%) and the one-year expected rate a year from now (8%):

(1 + 4%) x (1 + 8%)^(1/2) - 1 = 5.99%

Therefore, the closest answer is B, which is 6%.

Assume the Current One-Year Interest Rate on a Bond Is