Question

The current interest rate on a one-year bond is 4 percent and the current rate on a two-year bond is 4.4 percent. If the expectations theory of the term structure is correct, what is the one-year interest rate expected during Year 2? That is, compute the rate that is expected to exist only during Year 2. (Base your answer on an arithmetic average rather than a geometric average.)

8.4%

4.8%

0.4%

4.4%

4.2%

Answer 1

b.4.8%.

working:

based on arithmetic average as suggested in the question.

since current rate on two year bond is 4.4%

two years return will be 4.4+4.4 =>8.8 %.

now,

since one year bond returns 4%.

one year interest rate during year 2 will be 8.8% total return - 4.0% one year return =4.8%.