Question

Over the next three years, the expected path of 1-year interest rates is 4, 1, and 1 percent. The expectations theory of the term structure predicts that the current interest rate on 3-year bond is _____.(a) 1 percent.(b) 2 percent.(c) 3 percent.(d) 4 percent.(e) 5 percent.

Answer 1

B) 2 percent.

Step-by-step explanation:

to calculate the expected interest rates we just add the forward rates: 4 + 1 + 1 = 6, and then divide by 3 (the number of forward rates, not the number of years): 6 / 3 = 2

The expectations theory of the term structure states that investors will predict the value of future short term interest rates using the values of current forward rates.