Final answer:
The yield on a 2-year bond, assuming the expectations theory is accurate and with given yields of 7% for a 1-year bond and an expected future spot rate of 6%, would be approximately 6.5%.
Step-by-step explanation:
Assuming the expectations theory holds true, and given that the yield on a 1-year bond is 7% and the expected future spot rate for the next year is 6%, we can calculate the yield on a 2-year bond using the formula that equates the average yield of shorter-term investments to the yield of a longer-term investment. According to the expectations theory, the 2-year bond yield should be such that an investor would be indifferent between investing in two consecutive 1-year bonds and investing in one 2-year bond.
To calculate the yield on the 2-year bond (y2), we apply the formula: (1 + y1) * (1 + expected spot rate) = (1 + y2)2, where y1 is the yield on the 1-year bond. Substituting the values, we have: (1 + 0.07) * (1 + 0.06) = (1 + y2)2. Solving for y2, we find that the yield on the 2-year bond would be approximately 6.5%.