According to the expectations theory, the expected one-year interest rate in the second year is 1.0 percent. The expected one-year interest rate in the third year is 1.3 percent.
The expectations theory suggests that the long-term interest rates can be determined by the market's expectations of future short-term interest rates. In this case, we can use the interest rates on one-year, two-year, and three-year Treasury bonds to estimate the expected one-year interest rates in the second and third years.
To compute the expected one-year interest rate in the second year, we look at the rate on the two-year Treasury bond, which is 1.0 percent. This rate reflects the market's expectation of the average interest rate over the two-year period. Since the rate on the one-year bond is 0.7 percent, the market expects the interest rate to increase from 0.7 percent in the first year to 1.0 percent in the second year.
To compute the expected one-year interest rate in the third year, we look at the rate on the three-year Treasury bond, which is 1.3 percent. This rate reflects the market's expectation of the average interest rate over the three-year period. Since the rate on the two-year bond is 1.0 percent, the market expects the interest rate to increase from 1.0 percent in the second year to 1.3 percent in the third year.
Therefore, using the expectations theory, we can estimate that the expected one-year interest rate in the second year is 1.0 percent and the expected one-year interest rate in the third year is 1.3 percent.