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Assume that the current interest rate on a one-year bond is 8 percent, the current rate...

Assume that the current interest rate on a one-year bond is 8 percent, the current rate on a two-year bond is 10 percent, and the current rate on a three-year bond is 12 percent. If the expectations theory of the term structure is correct, what is the one-year interest rate expected during Year 3? (Base your answer on an arithmetic average rather than a geometric average.)

Group of answer choices

13%

14%

16%

12%

10%

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Answer #1

The current rate of interest on a 2 Year bond is 10%,

The current rate of interest on a 3 Year bond is 12%.

Let the rate of interest on a one year bond be X,

So,

( Rate of interest on a 2- year bond)^2 * ( rate of interest on a 1 -year bond) = ( rate of interest on a 3- year bond)^3

(1.1)^2 * ( 1 + x) = (1.12)^3

X = 16.1098

So, the one year interest rate in 3rd year is 16%.

The correct option is option C.

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