In: Economics
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?
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%.