Suppose that you could buy a one-year bond today, which has an interest rate of 3%....

Suppose that you could buy a one-year bond today, which has an interest rate of 3%. If you wait a year and buy a one-year bond then, the interest rate will be 4%. Two years from now, a one-year bond is expected to offer an interest rate of 5%. According to the expectations theory of the term structure of interest rates, what is the interest rate on a two-year bond today? What is the interest rate on a three-year bond today?

Expert Solution

Interest rate on one-year bond today = 3%

Interest rate on one-year bond one year from now = 4%

Calculate the interest rate on a two-year bond today -

Interest rate on two-year bond today = [Interest rate on one-year bond today + Interest rate on one-year bond one year from now]/2

Interest rate on two-year bond today = [3+4]/2 = 3.5

So,

According to the expectations theory of the term structure of interest rates, the interest rate on a two-year bond today is 3.5%.

Interest rate on one-year bond today = 3%

Interest rate on one-year bond one year from now = 4%

Interest rate on one-year bond two years from now = 5%

Calculate the interest rate on a three-year bond today -

Interest rate on two-year bond today = [Interest rate on one-year bond today + Interest rate on one-year bond one year from now + Interest rate on one-year bond two years from now]/3

Interest rate on two-year bond today = [3+4+5]/3 = 4

So,

According to the expectations theory of the term structure of interest rates, the interest rate on a three-year bond today is 4%.

Rahul Sunny answered 2 years ago

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