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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

EXPECTATIONS THEORY Interest rates on 4-year Treasury securities are currently 7%, while 6-year Treasury securities yield 7.5%. If the pure expectations theory is correct, what does the market believe that 2-year securities will be yielding 4 years from now? Calculate the yield using a geometric average.

Summary Introduction

To identify: The interest rate on 2 year treasury securities.

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

Explanation

Solution:

The items required for the calculation of yield on 2 year treasury securities are yield on 4 year securities and yield on 6 year securities.

Given,

Yield on 4 year securities is 7% or 0.07.

Yield on 6 year securities 7.5% or 0.075.

Formula to calculate the yield on 2 year securities derives from the formula of yield on 6 year securities,

(1+Yieldon6yearSecurities)6=[(1+Yieldon4yearSecurities)4×(1+Yieldon2yearSecurities)2](1+Yieldon2yearSecurities)2=[(1+Yieldon6yearSecurities)6(1+Yieldon4yearSecurities)4]

Substitute 0

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