Question

You observe the following market interest rates, for both borrowing and lending:
One-year rate = 5%
two-year rate = 6%
one-year rate one year from now = 7.25%
How can you take advantage of these rates to earn a riskless profit? Assume that the Pure Expectation Theory for interest rates holds.

2. “If bonds of different maturities are close substitutes, their interest rates are more likely to move together.” Is this statement true, false, or uncertain? Explain your answer.

Answer 1

As per pure expectation theory one year rate one year from no will be = (6%*2 - 5%)/(2-1)

= 7%

But the one year rate one year from now = 7.25%. Thus companies should take advantage of this riksless profit of .25% over the Pure expectation theory for interest rates.

Ans2) this is ture because as per liquidity theory and risk structure if the bonds of different maturities are close substitutes, that means that the shorter term bond interest rates will affect the longer term bond's interest rates as well.