For this question, assume that one- year and two- year bonds have the same risk; therefore, you can ignore risk here. Assume that there is arbitrage between one- year bonds and two- year bonds, we know that the expected rate of return on two- year bonds:
A) will be exactly half the rate of return on one- year bonds.
B) will equal the expected rate of return from holding a one- year bond for two years.
C) will equal the expected rate of return from holding a one- year bond for one year.
D) will be smaller than the expected rate of return from holding a one- year bond for one year.
E) will be larger than the expected rate of return from holding a one- year bond for one year.

Question

Quizplus · Accepted Answer

If there is arbitrage between one-year and two-year bonds, this means that the yields of the two bonds are not in equilibrium. If the yield on a two-year bond was lower than holding a one-year bond for two years, investors would simply buy the two-year bond and receive the higher yield. If the yield on a two-year bond was higher than holding a one-year bond for two years, investors could make a riskless profit by selling the two-year bond and investing in a one-year bond, with the expectation of rolling over that bond for a second year. Therefore, we can assume that the expected rate of return on two-year bonds is equal to the expected rate of return from holding a one-year bond for one year, making choice C the correct answer.

For This Question, Assume That One- Year and Two- Year