7. Pure expectations theory The pure expectations theory, or the expectations hy

Question

7. Pure expectations theory 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. False 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? 8.1260% 12.1412% 10.8984% 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 0.3500%, what is the market's estimate of the one-year Treasury rate one year from now? 10.0890% 8.8500% 11.2400% O 7.5230% Suppose the yield on a two-year Treasury se rity i5 5.83%, and the yield on a five-year Treasury security is 6.20%. Assuming that the pure expectations theory is correct, what is the market's estimate of the three-year Treasury rate two years from now? 6.45% 6.61% 6.53% o 7.10%

Explanation / Answer

True

1. one year treasury rate one year from now = 1.07572/1.0561 - 1 = 9.56%

2. one year treasury rate one year from now = 9.56 - 2*0.35 = 8.85%

3. three year rate two years from now now = (1.0625/1.05832)1/3 - 1 = 6.45%

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