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?
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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