Assume the expectations hypothesis regarding the term structure of interest rates is correct. Then, if the current two-year interest rate is 5% and the current one-year rate is 6%, then investors expect the future one-year rate to be:
A) 4%.
B) 5%.
C) 6%.
D) 1%.

Question

Quizplus · Accepted Answer

According to the expectations hypothesis, the current long-term rate (two-year rate in this case) is an average of the current and expected future short-term rates (one-year rates). Given a current two-year rate of 5% and a current one-year rate of 6%, for the average to be 5%, the expected future one-year rate must be 4%. This is because (6% + expected rate) / 2 = 5%, solving this equation gives an expected rate of 4%.

Assume the Expectations Hypothesis Regarding the Term Structure of Interest