Under the Expectations Hypothesis, what is the mean (mathematical mean, not meaning) of the excess return?

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Expert Solution

Excess rate of return value meaning that rate of return that would be demanded by investor for investing into the market for longer term bonds based upon the shorter term bonds and it will be helpful in prediction of rate of interest of longer term bonds in future.

Example of excess return can be represented by the following example-

Let's say you have two bonds,2 year Bond will be providing the interest rate of 20% whereas 1 year Bond will be providing the interest rate of 18%.

We can calculate the excess return by-

Adding the rate of interest on the second year bonds

(1+r)= (1+.2) and square it by 2, Since it is a 2 year Bond.

(1+.2)^2= 1.44

Now we will divide the 1.44 by rate of 1 year Bond and we will add one.

= (1.44/1.18)+1

= 1.22

Or it can be 22% expected rate of return on two year bonds in order to be advantageous if the investor wants to invest into those bonds so it will be the excess rate of return over 20% of 2%.

jeff jeffy answered 2 years ago

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