Question

The current market interest rate for one year maturity bond is 10%. The forward rate for a one year investment starting in one year from now is 8%. According to the expectations theory of term structure, the current two year maturity market interest rate is O 8%. larger than 10%. between 8% and 10%. O smaller than 8%.

Answer 1

From the expectations theory of term structure we know,

$(1+r_{2})^{2}=(1+r_{0,1})(1+f_{1,2})$

Where r2 is the two year maturity interest rate

$f_{1,2}$ is the forward rate for 1 year investment starting in one year from now=8%=.08

$r_{0,1}$ is the one year maturity rate.=10%=.1

Therefore

$(1+r_{2})^{2}=(1+0.1)(1+.08)$

(1+r2)^2=1.188

1+r2=1.089

Therefore,r2=.0899=8.99%

Therefore r2 is between 8% and 10%.