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The one-year, two-year, three-year, and four-year spot rates for the theoretical spot rate curve are 5.0%,...

The one-year, two-year, three-year, and four-year spot rates for the theoretical spot rate curve are 5.0%, 6.0%, 6.5%, and 7%, respectively. According the expectations theory for the term structure of interest rates, what is the expected 2-year interest rate 2 years from today? Assume annual compounding.

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Answer #1

Given 2 year spot rate 1r2 = 6%

4 year spot rate 1r4 = 7%

So according to expectetion theory, expected 2-year interest rate 2 E(2r2) years from today can be calculated as

E(2r2) = (((1+1r4)^4)/((1+1r2)^2))^(1/2) - 1 = ((1.07^4)/(1.06^2))^(1/2) - 1 = 8.01%

So, expected 2-year interest rate 2 years from today = 8.01%

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