Question

Suppose we have the yield and maturity information on treasury securities from a current yield curve. A 1-year T-bond currently yields 4.50% and a 3-year T-bond yields 9.80%. Assuming the pure expectations theory is correct, what is the market's forecast for interest rates on a 2-year treasury security, 1 year from now?

	a.	11.16%
	b.	13.44%
	c.	14.49%
	d.	26.67%
	e.	12.55%

Answer 1

Based on Pure Expectations Theory,

(1 + 3 Yr Yield)³ = (1 + 1 Yr Yield) * (1 + 2 Yr Yield 1 yr from now)²

(1 + 9.80%)³ = (1 + 4.50%) * (1 + 2 Yr Yield 1 yr from now)²

1.323753 = 1.0450 * (1 + 2 Yr Yield 1 yr from now)²

1.266749 = (1 + 2 Yr Yield 1 yr from now)²

1.1225 = 1 + 2 Yr Yield 1 yr from now

2 Yr Yield 1 yr from now = 0.1255

2 Yr Yield 1 yr from now = 12.55%