Question

Assume that the expectations theory holds and that liquidity and maturity risk premiums are zero. The annual rate of interest on a two-year Treasury bond is 10.5 percent and the rate on a one-year Treasury bond is 12 percent. What is the expected one-year interest rate during the second year?

Answer 1

Answer:

We expect for the secodn year interest rate to be 13.52%

Explanation:

The two years bond rate will be the result of the current one-year and the subsequent year expected rate

$(1+r_{y1})(1+r_{y2}) = (1+r_{two-years})^2$

Therefore:

$(1+0.105)(1+r_{y2}) = (1+0.12)^2\\(1+r_{y2}) = 1.12^2 \div 1.105\\r_{y2} = 1.12^2 \div 1.105 - 1$

r y2 = 0,13520