Question

A 2-Year bond offers an annual yield of 6%, and a 3-Year bond of the same risk offers an annual yield of 7.5% today. Under the Pure Expectations Theory, what should be the annual yield on a 1-Year bond which is issued after two years from today?

a) 6%
b) 7%
c) 8%
d) 9%

Answer 1

The annual yield on a 1-Year bond issued after two years from today, under the Pure Expectations Theory, should be 7.5%.

Step-by-step explanation:

Under the Pure Expectations Theory, the annual yield on a 1-Year bond issued after two years from today can be calculated by considering the current yields of the 2-Year and 3-Year bonds. The difference in yield between the two bonds indicates the expected change in interest rates over the next year. In this case, the 3-Year bond has an annual yield of 7.5% and the 2-Year bond has an annual yield of 6%. Therefore, the difference in yield is 1.5%.

Since the 1-Year bond will be issued two years from today, the market expectation is that the interest rates will increase by 1.5%. Therefore, the annual yield on the 1-Year bond should be 6% + 1.5% = 7.5%.