Question

Assume that the current interest rate on a one-year bond is 8 percent, the current rate on a two-year bond is 10 percent, and the current rate on a three-year bond is 12 percent. If the expectations theory of the term structure is correct, what is the one-year interest rate expected during Year 3? (Base your answer on an arithmetic average rather than a geometric average.)

Answer 1

16%

Step-by-step explanation:

Given that,

Current interest rate on a one-year bond = 8 percent

Current rate on a two-year bond = 10 percent

Current rate on a three-year bond = 12 percent

One-year interest rate expected during Year 3:

= Current rate on a three-year bond - Current rate on a two-year bond

= (3 × 12%) - (2 × 10%)

= 36% - 20%

= 16%