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Question

o Click here to read the eBook: Using the Yield Curve to Estimate Future Interest Rates EXPECTATIONS THEORY 7.9%, if the pure expectations theory is correct, what does the market interest rates on 4-year Treasury securities are currently s.7%, while 6-year Treasury securities yield round your intermediate calculations. Round your believe that 2-year securities will be yielding 4 years from now? Calculate the yield using a geometric average. Do not o answer to two decimal places 10. is. O Check My Work (3 remaining) 4 2 Ul

Explanation / Answer

According to Pure Expectations Theory, short term interest rates are indicators of the future long term interest rates.

Simply said, the theory mentions, that if you were to invest in a 2 year bond today, it would yield the same return as you would earn by investing in a 1 year bond today and post maturity of it, investing the proceeds in another one year bond (so the total investment duration still remains 2 years).

So applying the same theory, based on the information in question,

(1 + 6Yr Treasury rate)6 = (1 + 4Yr Treasury rate)4 (1 + 2YR Rate 4 Yr from Now)2

(1 + 7.9%)6 = (1 + 5.7%)4 (1 + 2YR Rate 4 Yr from Now)2

1.5781 = 1.2482 * (1 + 2YR Rate 4 Yr from Now)2

(1 + 2YR Rate 4 Yr from Now)2 = 1.2642

1 + 2YR Rate 4 Yr from Now = 1.1243

2YR Rate 4 Yr from Now = 12.43% --> Answer

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