Question

Suppose the interest rate on a 1-year T-bond is 5.0%, that on a 2-year T-bond is 6.0%, and that on a 3-year T-bond is 8.0%. Assuming the pure expectations theory, what does this mean for expected 1-year rates investors can expect to receive during year the second and third years?

Answer 1

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Answer:

(1 + Int rate on 2 -year)² = ( 1 + Int rate on 1 -year) * ( 1 + 1 Year rate in second year)

=> (1 + 0.060)² = (1+0.050) * ( 1 + 1 Year rate in second year)

=> ( 1 + 1 Year rate in second year) = 1.0701

=> 1 year rate in second year = 7.01%

(1 + Int rate on 3 -year)³ = ( 1 + Int rate on 1 -year) * ( 1 + 1 Year rate in third year)²

=> ( 1 + 1 Year rate in third year)² = (1.08^³ / ( 1.05))

=> 1 Year rate in third year = 9.532%