Fundamentals of Financial Manageme...
Solutions
Fundamentals of Financial Manageme...
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.
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.
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,
Substitute 0
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