Question

Suppose the annalized yield on a one year security today is 0.03. The markets expect the annualized yield on a one year security to be 0.02 one year from today, 0.02 two years from today, and 0.04 three years from today. Using the pure expectations theory, calculate the annualized yield on a four-year security today.

Answer 1

The pure expectations theory suggests that the yield on a longer-term security can be estimated by taking an average of the expected future short-term yields. In this case, the annualized yield on a four-year security today, based on the given information, is 2.75%.

Step-by-step explanation:

The pure expectations theory suggests that the yield on a longer-term security can be estimated by taking an average of the expected future short-term yields. In this case, using the pure expectations theory, we can calculate the annualized yield on a four-year security today.

Based on the given information, the expected annualized yields for each year are 0.03, 0.02, 0.02, and 0.04 respectively. Taking the average of these yields, we get:

(0.03 + 0.02 + 0.02 + 0.04) / 4 = 0.0275 or 2.75%

Therefore, the annualized yield on a four-year security today, according to the pure expectations theory, is 2.75%.