Question

The pure expectations theory, or the expectations hypothesis, asserts that long-term interest rates can be used to estimate future short-term interest rates.

Based on the pure expectations theory, is the following statement true or false?

The pure expectations theory assumes that investors do not consider long-term bonds to be riskier than short-term bonds.

True

False

The yield on a one-year Treasury security is 4.6900 %, and the two-year Treasury security has a 6.3315 %yield. Assuming that the pure expectations theory is correct, what is the market's estimate of the one-year Treasury rate one year from now? (Note: Do not round your intermediate calculations.)

9.1186 %  10.1585 %  7.9988 %  6.799 %

Recall that on a one-year Treasury security the yield is 4.6900 %and 6.3315 %on a two-year Treasury security. Suppose the one-year security does not have a maturity risk premium, but the two-year security does and it is 0.2 %. What is the market's estimate of the one-year Treasury rate one year from now? (Note: Do not round your intermediate calculations.)

6.454 %   9.643 %   8.6559 %    7.5929 %

Suppose the yield on a two-year Treasury security is 5.83 %, and the yield on a five-year Treasury security is 6.20 %. Assuming that the pure expectations theory is correct, what is the market's estimate of the three-year Treasury rate two years from now? (Note: Do not round your intermediate calculations.)

6.53 %   5.46 %    6.69 %   6.45 %

Answer 1

Answers as below:
1)	TRUE
2)	Yield =	(1+6.3315%)^2/(1+4.69%) -1
	Yield =	7.9987%
	So correct answer is 7.9988%
3)	Yield on two yr bond (reduced by maturity premium) =				6.3315% - 0.2%
	Yield on two yr bond (reduced by maturity premium) =				6.1315%
	Required yield =	(1+6.1315%)^2/(1+4.69%) - 1
	Required yield =	7.5928%
	So correct answer is 7.5929%
4)	Required yield =	((1+6.20%)^5/(1+5.83%)^2)^(1/3)-1
	Required yield =	6.45%