Question

In: Finance

State the expectations theory and explain its significance. Using the generalized equation of the expectations theory...

State the expectations theory and explain its significance. Using the generalized equation of the expectations theory of the term structure of interest rates, calculate today's four-year rate, assuming that the current one-year, 6% rate is expected to rise by one percentage point in each of the next three years.

Solutions

Expert Solution

According to The Expectations Theory, long-term interest rates hold a forecast for short-term interest rates in the future.

Now, 1 year rate in Year 1 = 6%,

1 year rate in Year 2 = 7%

1 year rate in Year 3 = 8%

1 year rate in Year 4 = 9%

Assume you invest $100 in Year 1.

At the end of Year 1, total amount = $100 * (1 + 6%) = $106. This would be invested in Year 2 at 7%

At the end of Year 2, total amount = $106 * (1 + 7%) = $113.42. This would be invested in Year 3 at 8%

At the end of Year 3, total amount = $113.42 * (1 + 8%) = $122.4936. This would be invested in Year 4 at 9%

At the end of Year 4, total amount = $122.4936 * (1 + 9%) = $133.518

Now, based on expectations theory, whether you invest in a 4 year bond or invest in 1 year bonds in each of the 4 years, it is the same.

So $100 invested today, should become $133.518 in 4 years.

133.518 = 100 * (1 + r)4

1.33518 = (1 + r )4

(1 + r) = 1.07494

r = 7.494%



Related Solutions

a. State the Pure (Unbiased) Expectations Theory. b. How is the liquidity preference theory supposed to...
a. State the Pure (Unbiased) Expectations Theory. b. How is the liquidity preference theory supposed to address the shortcomings of the pure expectations theory? (Hint: Time to maturity and liquidity premium) c. Briefly discuss how the liquidity preference theory explains the shape of the yield curve. (HInt: Time to maturity and liquidity premium)
a) State the Pure (Unbiased) Expectations Theory. b) How is the liquidity preference theory supposed to...
a) State the Pure (Unbiased) Expectations Theory. b) How is the liquidity preference theory supposed to address the shortcomings of the pure expectations theory? [Hint: Time to maturity and liquidity premium] c) Briefly discuss how the liquidity preference theory explains the shape of the yield curve. [Hint: Time to maturity and liquidity premium]
a. State the Pure (Unbiased) Expectations Theory. b. How is the liquidity preference theory supposed to...
a. State the Pure (Unbiased) Expectations Theory. b. How is the liquidity preference theory supposed to address the shortcomings of the pure expectations theory? (Hint: Time to maturity and liquidity premium) c. Briefly discuss how the liquidity preference theory explains the shape of the yield curve. (HInt: Time to maturity and liquidity premium)
state the learned hand equation and explain its components and interpretation
state the learned hand equation and explain its components and interpretation
5. Pure expectations theory The pure expectations theory, or the expectations hypothesis, asserts that long-term interest...
5. Pure expectations theory The pure expectations theory, or the expectations hypothesis, asserts that long-term interest rates can be used to estimate future short-term interest rates. Based on the pure expectations theory, is the following statement true or false? The pure expectations theory assumes that a one-year bond purchased today will have the same return as a one-year bond purchased five years from now. False True The yield on a one-year Treasury security is 4.4600%, and the two-year Treasury security...
6. Pure expectations theory The pure expectations theory, or the expectations hypothesis, asserts that long-term interest...
6. Pure expectations theory The pure expectations theory, or the expectations hypothesis, asserts that long-term interest rates can be used to estimate future short-term interest rates. The yield on a one-year Treasury security is 4.9200%, and the two-year Treasury security has a 6.6420% yield. Assuming that the pure expectations theory is correct, what is the market’s estimate of the one-year Treasury rate one year from now? (Note: Do not round your intermediate calculations.) 9.5672% 10.6582% 7.1335% 8.3923% Recall that on...
Differentiate between public and private savings using the national income accounts equation and explain the significance...
Differentiate between public and private savings using the national income accounts equation and explain the significance of each type of savings. Use the loanable funds market diagram to show what happens to interest rate and quantity of loanable funds if government revenues exceed its spending? Explain why it is important for a nation to increase savings? Label the diagram completely. You can draw the graph with a pen and insert a picture here.
Q2. a) Explain the penetration test carried out on bitumen, state its significance and draw the...
Q2. a) Explain the penetration test carried out on bitumen, state its significance and draw the test apparatus. b). Mention the main factors considered in the choice of construction materials at the design office – is any of them more important than the other? c). What factors affect the weldability of steel? d). Consider the iron value chain from material extraction to disposal, at what point according to your assessment is the most energy used? As a design engineer, at...
Explain the concept of the yield curve for bonds and distinguish between the expectations theory and...
Explain the concept of the yield curve for bonds and distinguish between the expectations theory and market segmentation theory of the term structure of interest rates.                                                        Discuss the role of Credit Default Swaps (CDS) in transferring the default risk on corporate bonds, in the context of Global Financial Crisis 2008.
1. Stock Prices, Expectations, and Policy Changes Explain, using the expectations model (and their role in...
1. Stock Prices, Expectations, and Policy Changes Explain, using the expectations model (and their role in determining asset prices) how the stock market is likely to react to each of the following scenarios: a) The Fed, as expected, raises the policy rate by 0.25 percentage points (25 basis points). b) The Fed unexpectedly raises the policy rate by 0.50 percentage points (50 basis points). c) At a meeting in which a rate hike was widely anticipated, the Fed surprises observers...
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT