Question

3. The one-year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%, 9%, 10.5%, 13%, 14.5%, 16%, and 17.5%. Using the expectations theory, what will be the interest rates on a three-year bond, a six-year bond, and a nine-year bond?

Answer 1

Expectation theory predicts the short-term interest rates by taking average of current-interest rates over a period of time. The interest rates for the following securities using the expectation theory would be:

Interest rate on 3 year bond =
`(3+4.5+6)/(3)` = 4.5%

Interest rate on 6 year bond =
`(3+4.5+6+7.5+9+10.5)/(6)` = 6.75%

Interest rate on 9 year bond =
`( 3+4.5+6+7.5+9+10.5+13+14.5+16)/(9)` = 9.33%