Question

The yield on a one-year Treasury security is 4.9200%, and the two-year Treasury security has a 7.3800% yield. Assuming that the pure expectations theory is correct, what is the market's estimate of the one-year Treasury rate one year from now? ? 8.4150% O 9.9000% O 11.2860% 0 12.573096 Recall that on a one-year Treasury security the yield is 4.9200% and 7.3800% on a two-year Treasury security. Suppose the one-year security does not have a maturity risk premium, but the two-year security does and it is 0.4000%. What is the market's estimate of the one-year Treasury rate one year from now? O 7.718096 9.080090 O 11.5320% O 10.3510%

Answer 1

Answer:

Option (b) is correct.

Option (b) is correct.

Explanation:

1. Pure Expectation Theory :

Each option must provide the same amount of cash at the end of 2 years, which implies that,

CF at the end of year 2 = CF at the end of year 1

[tex](1+0.0738)^{2} = (1+0.0492) (1+x) [tex\]

Hence, x = 9.90

so the market's estimate of the one year Treasury rate one year from now it will be 9.90%

2. In case of maturity risk premium, the cash flow of two year treasury security will reduce, it will be:

= 7.38 - 0.40

= 6.98.

Hence, Treasury Rate will be as follows:

CF at the end of year 2 = CF at the end of year 1

[tex](1+0.0698)^{2} = (1 + 0.0492) (1 + x)[tex\]

x = 9.080%