Question

Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. (Input your answers as a percent rounded to 2 decimal places.)
  

	Interest Rate
1-year T-bill at beginning of year 1	4	%
1-year T-bill at beginning of year 2	6	%
1-year T-bill at beginning of year 3	7	%
1-year T-bill at beginning of year 4	9	%

	Expected Return
2-year security		%
3-year security		%
4-year security		%

Answer 1

Solution

As per the expectations hypothesis theory, expected return for the 2 year security is the average of the expected yields of two one-year T-bills, expected return for the 3 year security is the average of the expected yields of three one-year T-bills and expected return of the 4 year security is the average of the expected yields of the four one-year T-bills.Hence, the expected return is calculated as follows:

Particulars	Calculation	Expected Return(%)
2 year Security	(4 + 6) / 2 = 5.00 %	5.00%
3 year security	(4 + 6 + 7) / 3 = 5.67 %	5.67%
4 year security	(4 + 6 +7 + 9) / 4 = 6.50 %	6.50%