Question

Suppose the interest rate on a 1-year T-bond is 1.75% and that on a 2-year T-bond is 4.25%. Assume that the pure expectations theory is NOT valid, and the MRP is zero for a 1-year T-bond but 0.25% for a 2-year bond. What is the equilibrium market forecast for 1-year rates 1 year from now?

a. 2.50%

b. 3.40%

c. 4.67%

d. 6.30%

e. 6.85%

Answer 1

Given that The interest rate on 1-year bond is 1.75% and the interest rate on a year bond is 425% The materity Jisk premium is o for 1-year bond and 0.95% fox Q-year bond Expected getuan on l-year Sexley bonds is calculated ay aeturn on Expected year bond - 2 year bond -mat premium. 0.25% 4.25% 54% Equi? I briu o manicet forecast for t-year from now, then 1 year bond one yecia from now = forecast on 2-year bond = (1+0.01 +5)(1+x)=(1+0.04) (1.0175)(1+x) = (pouz? = (1.0175)(1+x) = (1.0816) 14x = 1.0816 - 10175 1 + 21.062992 1.06299-1 ::option des correct [x = 6.299 = 6-30%.