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kmarks People Window Help xAplia: Student Question courses.aplia.com/af/servlet/quiz?quiz action takeQuiz&qu; iz, probGuid-QNAPCOA8010100000041ca 26100a00 Attempts: 7. Pure expectations theory The pure expectations theory, or the expectations hypothesis, asserts that long-term interest rates can be used to Keep the Highest: /4 Aa Aa estimate future short-term interest rates. Based on the pure expectations theory, is the following statement true or falise? The pure expectations theory assumes that a one-year bond purchased today will have the same return as a one-year bond purchased five years from now. O False O True The yield on a one-year Treasury security is 5.6100%, and the two-year Treasury security has a 7.5700% 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? 10.8984% 8.1260% 12.1412% 9.5600% Recall that on a one-year Treasury security the yield is 5.6100% and 7.5700% on a two-year Treasury security. Suppose the one-year security does not have a maturity risk premium, but the two-year security does and it is 0.3000%, what is the market's estimate of the one-year Treasury rate one year from now? 7.6160% 10.2 140% O 11.3790% ? 8.9600%

Explanation / Answer

According to Pure Expectations Theory, The hypothesis that long-term interest rates contain a prediction of future short-term interest rates. Based on this hypothesis, if an amount is invested in a 2 year bond, then the amount of return will be equal if we invested in a 1 year bond and then proceeds post maturity are invested in another 1 year bond (total investment duration remains 2 year here as well).

QUESTION 1 - FALSE

Based on the explanation above, pure expectation theory does not assert that the 1 year bond will have the same return today and after 5 years. According to the theory, rate of return on 1 year bond 5 years later would depend upon the long term rate for 5 year.

QUESTION 2

(1 + 2 Yr Spot Rate)2 = (1 + 1 Yr Spot Rate) * (1 + 1Yr forward rate 1 Yr from now)

(1 + 7.57%)2 = (1 + 5.61%) * (1 +  1Yr forward rate 1 Yr from now)

1Yr forward rate 1 Yr from now = (1.1571/1.0561) - 1 = 9.5664%

Hence, answer is 9.5600%

QUESTION 3

2 Yr Spot Rate sans Maturity Risk Premium (MRP) = 7.57% - 0.30% = 7.27%

(1 + 2 Yr Spot Rate w/o MRP)2 = (1 + 1 Yr Spot Rate) * (1 + 1Yr forward rate 1 Yr from now)

(1 + 7.27%)2 = (1 + 5.61%) * (1 +  1Yr forward rate 1 Yr from now)

1Yr forward rate 1 Yr from now = (1.150685/1.0561) - 1 = 8.9561%

Hence, answer is 8.9600%

QUESTION 4

(1 + 5 Yr Spot Rate)5 = (1 + 2 Yr Spot Rate)2 * (1 + 3Yr forward rate 2 Yr from now)3

(1 + 6.20%)5 = (1 + 5.83%)2 * (1 + 3Yr forward rate 2 Yr from now)3

3Yr forward rate 2 Yr from now = 6.45%

1Yr forward rate 1 Yr from now = (1.1571/1.0561) - 1 = 9.5664%

Hence, answer is 9.5600%

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