Chapter 6, Problem 15P

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# EXPECTATIONS THEORY Assume that the real risk-free rate is 2% and that the maturity risk premium is zero. If a 1-ycar Treasury bond yield is 5% and a 2-year Treasury bond yields 7%, what is the 1-year interest rate that is expected for Year 2? Calculate this yield using a geometric average. What inflation rate is expected during Year 2? Comment on why the average interest rate during the 2-year period differs from the 1-year interest rate expected for Year 2.

Summary Introduction

To analyze: The expected interest rate for year 2, yield, expected inflation rate during year 2 and the reason of the difference between the average interest rate during 2-year period and 1-year period for the year 2.

Introduction:

Expectation Theory:

Expectation theory estimates the future interest without taking into consideration of maturity risk. According to the expectation theory, the yield curve of investment is totally depending upon the future expectation of investors.

Explanation

The items required for the computation of the expected interest rate are Treasury bond yield for 1-year and Treasury bond yield for 2-year.

Given,

The Treasury bond yield for 1-year is 5% or 0.05.

The Treasury bond yield for 2-year is 7% or 0.07.

Formula to calculate the expected interest rate derives from the formula of interest rate for the next year,

(1+TreasuryāBondāYieldāforā2-Year)2=((1+TreasuryāBondāYieldāforā1-Year)1(1+ExpectedāInterestāRate)1)(1+ExpectedāInterestāRate)1=((1+TreasuryāBondāYieldāforā2-Year)2(1+TreasuryāBondāYieldāforā1-Year)1)

Substitute 0.07 for Treasury bond yield for 2-year and 0.05 for Treasury bond yield for 1-year.

(1+ExpectedāInterestāRate)1=(1+0

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