Question

The interest rate on a one-year bond selling today is 3% and the interest rate on a two-year bond selling today is 4%. According to expectations theory people expect the interest rate on a one-year bond selling one year from today to be about

Answer 1

Let R1 = 0.03

Let R2 = 0.04

1. First step is to add one to the two-year bond’s interest rate i.e R2 = 1 + R2 = 1.04

2. Square the result obtained in first step: (1.04)² = 1.0816

3. Third step is to divide the result obtained in second step by the current one-year interest rate plus one

(1.0816)/(1 + 0.03) =   (1.0816)/(1.03) = 1.050097

4. To find out the interest rate on a one-year bond selling one year from today, subtract 1 from the result obtained in step 3:

1.050097 - 1 = 0.050097 or 5.0097%