The pure expectations theory, or the expectations hypothesis, asserts that long-
ID: 1189998 • Letter: T
Question
The pure expectations theory, or the expectations hypothesis, asserts that long-term interest rates can be used to estimate future short-term interest rates. Based on the pure expectations theory, is the following statement true or false? The pure expectations theory assumes that investors do not consider long-term bonds to be riskier than short-term bonds. True False The yield on a one-year Treasury security is 4.2300%, and the two-year Treasury security has a 5.0800% yield. Assuming that the pure expectations theory is correct, what is the market's estimate of the one-year Treasury rate one year from now? 5.0490% 6.7716% 7.5438% 5.9400%Explanation / Answer
(a) FALSE
Pure expectations theory assumes that investors assess the riskiness by maturity of an investment, therefore the higher the maturity of an investment, the riskier it is and the higher will be the required interest rate. So, long term interest rate will be higher than short term interest rate.
(b) If the 1-year treasury rate 1 year from now be R, then
(1.0423) x (1 + R) = (1.0508)2
(1.0423) x (1 + R) = 1.1042
1 + R = 1.1042 / 1.0423 = 1.0594
R = 1.0594 - 1 = 0.0594 = 5.94%
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