According to the expectations theory of the term structure of interest rates, if the interest rate on a one-year bond today is 3.0 percent, the expected interest rate on a one-year bond one year from now is 4.0 percent, and the expected interest rate on a one-year bond two years from now is 4.5 percent, then the interest rate on a two-year bond today is
A)3.00 percent.
B)3.50 percent.
C)3.83 percent.
D)4.00 percent.

Question

Quizplus · Accepted Answer

According to the expectations theory, the interest rate on a longer-term bond is the geometric average of the expected future short-term interest rates. So, the expected interest rate on a two-year bond is the geometric average of the expected one-year interest rates:

[(1 + 0.04) × (1 + 0.045)]^(1/2) - 1 = 3.83%

Therefore, the interest rate on a two-year bond today is 3.83%.

According to the Expectations Theory of the Term Structure of Interest