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 5 % 1-year T-bill at beginning of year 3 9 % 1-year T-bill at beginning of year 4 11 %

Answer 1

Answer:

The expected return for securities with maturities of two, three, and four years is as follows:

Expected Return 2 year Security=4.50 %

Expected Return 3 year security= 6 %

Expected Return 4 year security=7.25 %

Explanation:

According to the expectations hypothesis theory, the expected return for the 2 year security is the average of the expected yields of two one-year T-bills, for the 3 year security is the average of the expected yields of three one-year T-bills and the 4 year security is the average of the expected yields of the four one-year T-bills.

Therefore, in order to calcuate the expected return for each year we have to use the following formula:

Expected Return 2 year Security=(4 + 5) / 2 = 4.50 %

Expected Return 3 year security=(4 + 5 + 9) / 3 = 6 %

Expected Return 4 year security=(4 + 5 +9 + 11) / 4 = 7.25 %