According to the expectations theory of the term structure of interest,if the 1-year bond rate today is 6% p.a.and the 2-year bond rate today is 7% p.a. ,what is the 1-year bond rate next year?
A)6%
B)6.75%
C)7.5%
D)8%

Question

Quizplus · Accepted Answer

The expectations theory suggests that the future short-term interest rate is the rate that makes the expected return on a sequence of short-term bonds equal to the return on a long-term bond. Here, the expected 1-year rate next year (x) can be calculated using the formula: (1 + 6%)(1 + x) = (1 + 7%)^2. Solving for x gives approximately 8%.

According to the Expectations Theory of the Term Structure of Interest,if