Suppose the interest rate on a 2-year treasury security is 4.75% and the interes

Question

Suppose the interest rate on a 2-year treasury security is 4.75% and the interest rate on a 5-year treasury security is 6.20%. Assuming that the pure expectations theory is correct, what is the market’s estimate of the 3-year treasury rate two years from now?

-6.53%

-7.10%

-6.85%

-7.18%

-6.45%

Now assume that the 2-year treasury requires a 0.15% maturity risk premium and the 5-year treasury rate has a 0.30% maturity risk premium. The interest rate on a 2-year and 5-year treasury securities is 4.75% and 6.20% respectively. What is the market’s estimate of the 3-year treasury rate two years from now?

-6.61%

-6.53%

-6.37%

-6.13%

-6.78%

Explanation / Answer

Answer: 7.18%

3-year rate today                                                  4.75%

5-year rate today                                                  6.20%

Maturity of longer bond                                                2

Ending return if buy the 5-year bond = needed return on series of 3-year bonds                                                                   1.127844

Rate of return, or yield, on a 1-year bond 1 year from now:            

X in this equation: (1.0475)(1 + X) = 1.127844

x=7.18%

Answer: 6.78%

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