Question

Problem 2 Estimating Future Interest Rates (10 points) Suppose the interest rate on a 1-year T-bond is 4.00% and that on a 3-year T-bond is 0.9070- Assuming the pure expectations theory is correct, what is the market's forecast for 2-year rates 1 year from now? (10 points)

Answer 1

Market's forecast for 2-year rates 1 years from now = ((1 + Interest rate on 3 year T-bond)^3 / (1 + Interest rate on 1 year T-bond)^1)^(1/2) - 1
= ((1 + 6.90%)^3 / (1 + 4%)^1)^(1/2) - 1
= (1.2216 / 1.04)^(1/2) - 1
= 1.0838 - 1
= 0.0838 or 8.38%

Market's forecast for 2-year rates 1 years from now = 8.38%