Question

If the interest rate on a one-year bond selling today is 2%, the expected interest rate...

If the interest rate on a one-year bond selling today is 2%, the expected interest rate on a one-year bond one year from today is 5%, and the liquidity premium is zero, what does expectations theory imply that the interest rate on a two-year bond selling today would be?

  1. What does this do to the price of one-year bonds?
  2. What does this do to the yield on one -year bonds?
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Answer #1

Interest rate of 2 year bond selling today = ((1 + 1 year interest) * (1 + 1 year forward interest))^(1/2) - 1

Interest rate of 2 year bond selling today = (1.02 * 1.05)^(1/2) - 1

Interest rate of 2 year bond selling today = 1.03489 - 1

Interest rate of 2 year bond selling today = 3.49%

A. the price of the one year will decrease because the 2 year bond is offering higher return of 3.49%

B. The yield of the one year bond will increase due to decrease in price of the one year bond

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