Question

Assume that the expectations theory holds and that liquidity and maturity risk premiums are zero. The annual rate of interest on a two-year Treasury bond is 10.5 percent and the rate on a one-year Treasury bond is 12 percent. What is the expected one-year interest rate during the second year?

Answer 1

We expect for the secodn year interest rate to be 13.52%

Step-by-step explanation:

The two years bond rate will be the result of the current one-year and the subsequent year expected rate

`(1+r_(y1))(1+r_(y2)) = (1+r_(two-years))^2`

Therefore:

`(1+0.105)(1+r_(y2)) = (1+0.12)^2\\(1+r_(y2)) = 1.12^2 / 1.105\\r_(y2) = 1.12^2 / 1.105 - 1`

r y2 = 0,13520