Question

If the current 3-year interest rate is 2.6% and the expected 1-year interest rate three years...

If the current 3-year interest rate is 2.6% and the expected 1-year interest rate three years from now is 1.0%, what is the interest rate on 4-year bond today according to the expectations theory?

a. 4.4 percent.

b. 1.1 percent.

c. 2.2 percent.

d. 2.0 percent.

Homework Answers

Answer #1

Expectation theory tells us that:

In = (i0 + i1 + ------+ in-1)/n

where In = interest rate on 4-year bond today and in = expected 1-year interest rate n years from now.

Using above data we have :

Now we have I3 =2.6% and I3 = (i0 + i1 + i2)/3 => (i0 + i1 + i2) = 3*2.6 = 7.8%

So, I4 = (7.8 + i3)/4

It is given that expected 1-year interest rate three years from now is 1.0% => i3 = 1%

So, I4 = (7.8 + 1)/4 = 2.2%

Thus, current 4-year Bond interest rate = 2.2%

Hence, the correct answer is (c) 2.2 percent.

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