Question

Expectation Hypothesis, 30 points1. Explain what is the expectation hypothesis.2. The one-year interest rate is 4% in 2019. The two year interest rate is 5% 2019 and thethree-year interest rate is 6% in 2019. According to the expectation hypothesis, what isyour expectation of one-year interest rate in 2020 and 2021 respectively? Explain yourcalculation.

Answer 1

Please take a look to the following explanation

Step-by-step explanation:

1) The expectations hypothesis of the term structure of interest rates is the proposition that the long-term rate is determined purely by current and future expected short-term rates, in such a way that the expected final value of wealth from investing in a sequence of short-term bonds equals the final value of wealth from investing in long-term bonds.

2) For 2019, (1 + f1t) = (1 + i2t)2/(1 + i1t) = (1.05)2/(1.04)

Or, (1 + f1t) = 1.0600

Or, f1t = 0.06 or 6%

For 2020, (1 + f2t) = (1 + i3t)3/(1 + i2t)2 = (1.06)3/(1.05)2

or, (1 + f2t) = 1.080

or, f2t = 0.08 or 8%