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Suppose the interest rate on a 1-year T-bill is 5.0% and on a 2 year T-note...

Suppose the interest rate on a 1-year T-bill is 5.0% and on a 2 year T-note is 7.0%. Assuming the pure expectations theory is correct, what is the market's forecast for 1-year rates 1 year from now?

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Answer #1

(1+ one year rate)(1+ one year future rate) = (1+ two year rate) 2

(1+ 5%) (1+ one year future rate) = (1+ 7 %) 2

(1+ 0.05) (1+ one year future rate) = (1+ 0.07) 2

(1.05) (1+ one year future rate) = (1.07) 2

(1.05) (1+ one year future rate) = 1.1449

1+ one year future rate = 1.1449/1.05

1+ one year future rate = 1.09038095238095

One year future rate = 1.09038095238095 – 1 = 0.09038095238095 or 9.04 %

Market's forecast for 1-year rates 1 year from now is 9.04 %

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