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%